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With the exception of my parents, Ben Graham influenced me more than probably anyone, even though I never had the benefit of actually hearing him speak. The below video provides video footage from his Columbia College, Security Analysis course. Enjoy!

“Um, yeah, my question is kind of broad?” begins a gawky guy who identifies himself as a Tufts student interning in Client Solutions. “Earlier this summer we had the LIBOR scandal that was involved with a lot of the big banks and led to the resignation of the CEO from Barclays. More recently we had Sandy Weill saying the banks needed to be broken up. With the banks so big, how is it possible to monitor every aspect?”

Next up is a scruffy-haired kid from the University of Miami: “With banking in a secular or cyclical decline, do you truly believe that this is a good place for us to start our careers, considering all of the other opportunities available to us?” he asks.

“In an industry associated with surprisingly low standards?…?” a woman from Emory University starts to say.

“Whoa, whoa, whoa,” the JPMorgan Chase CEO interrupts, leaning into the microphone and peering out at the several hundred summer interns, sweating in their first business clothes, that have gathered in the auditorium of the former Bear Stearns building for a friendly Q&A session with the boss. “Before you go to the next level of generalizing, saying, ‘all bankers,’ ‘all banks.’ I don’t like that.” The room murmurs its assent as Dimon, pacing onstage in his summer uniform of a suit and no tie, warms to his topic. “I don’t buy this thing that our industry is responsible for all the ills of the world. We have great people at JPMorgan Chase. We operate with a lot of rigor. Our clients are happy with us. Sure, we make mistakes, like we have got this Whale thing. Businesses make mistakes. So we’ve got to clean them up, learn from them, and get better. And I want you to know the London Whale issue is dead,” he says. “The Whale has been harpooned. Dessicated. Cremated.” His voice carries over the students’ laughter. “I am going to bury its ashes all over.”

He’d certainly like to. But, “there’s a tail,” he concedes to me on a recent morning, sitting in his 48th-floor office, a homey space filled with knickknacks and family photos that requires passage through a gauntlet of machines and a security guard escort to reach. He means “tail” in the business-y sense, as in: The trading scandal that rocked the firm at the beginning of the year will have lasting repercussions. If he finds it at all amusing that actual whales have tails, he doesn’t show it. With his boyishly wavy hair and down-home platitudes, Dimon can come across like an overgrown frat boy. (“Don’t sell a product to anyone you wouldn’t sell your motha,” he likes to warn employees, in his Marky Mark–via–Queens accent.) But when it comes to this topic, he’s sober as a judge. You wouldn’t say his swagger has been trampled, more effortfully tempered. “I never get anxious,” he announces at one point. “I don’t normally.” This spring, though, was different.

At first, when questions came up about the activities of Bruno Iksil, a trader in the London-based Chief Investment Office who had taken such a massive position in the credit market that it caused waves in the sector (hence the nickname), Dimon was dismissive. “It’s a complete tempest in a teapot,” he told analysts, a comment that would come back to haunt him when repeated, ad nauseam, in escalating news stories that reported the London Whale’s activities had cost the firm $2 billion, then $3 billion, then close to $6 billion and counting.

“I had been told a whole bunch of stuff that made me think it was a tempest in a teapot,” he says now, adding that it was only when he laid eyes on the positions that he realized the extent of the problem. “There was a moment of, I can’t believe what we have.” For Dimon, who had boasted in the past of the bank’s risk management and “fortress balance sheet,” the blunder was particularly, specifically embarrassing, like Jerry Falwell getting caught with a hooker. “I saw it all pass in front of my eyes,” he says. “I saw the headlines, the investigations, the uproar, the breathlessness. ‘Dimon Loses Luster,’ ‘Dimon in the Rough.’ I told everyone, ‘This is going to be bad, it’s going to go on, and we can’t get out of it. So put your jerseys on: We’re going to wrestle this thing down and fix it.’?” He went on Meet the Press: “We made a terrible, egregious mistake,” he told David Gregory, his Droopy-the-dog eyes conveying sincerity. Iksil and those who oversaw him were swiftly disappeared; top management was reorganized. “We had to review thousands of e-mails, minutes of tapes,” Dimon recounts. “We cleaned up the risk. It scared the daylights out of our people. We crossed the t’s and dotted the i’s and put in new rules, and we’re fine.” He says all this quickly, as though he’s told this story a million times and thinks this should have been the end of it.

Of course, this wasn’t the end of it, and Dimon has told this story a million times, including to the Senate Banking Committee, which called him down to explain himself in June. “That I did not expect,” he says.

Why would he have? Dimon has long enjoyed favored status in Washington. “That Jamie Dimon, he’s wonderful” one female senatorial staffer said to me last year, an unmistakable blush rising on her cheeks. After his eleventh-hour rescue of Bear Stearns in 2008, Dimon was elevated to the level of American hero. Or at least, as the Times put it, “America’s Least-Hated Banker.” But in the past few years, he’s been testing public affection by objecting—aggressively, sometimes callously—to what he sees as regulatory overreach. He expressed particular disdain for portions of the Volcker rule, a piece of legislation that seeks to limit banks’ proprietary trading. “Paul Volcker by his own admission has said he doesn’t understand capital markets,” Dimon told the Fox Business Network. “Honestly, he has proven that to me.” Meanwhile, the media that had lionized Dimon began to chafe at some of his condescending comments. “You don’t even make any money,” he told one group of reporters, mockingly.

This May, when JPMorgan disclosed the Whale’s losses, all of this pent-up resentment was unleashed into the unseasonably warm air. “The pedestal that [Dimon] so carefully constructed for himself is now vacant,” Graydon Carter wrote in Vanity Fair. Occupy Wall Streeters tweeted gleefully. Goldman Sachs, at long last, felt the Mantle of Evil being gently lifted off its shoulders. Representative Barney Frank and Senator Carl Levin went on television and sweatily proclaimed the losses would have been prevented under … yes! the very same aspects of the proposed Volcker Rule that Dimon had called “unnecessary.”

“This was perfect for everyone who was pushing for more regulation,” he says. “We handed it to them on a silver platter. And then I made that stupid comment about a tempest in a teapot.”

But it almost seems like he regrets the phrasing more than the actual sentiment. Seeing the losses bandied about as though it were the second coming of tarp clearly grates on his nerves. “It’s such a large number, but if you put it in perspective a little bit, if you had a $100 million market-cap bank that made something like $3 million that quarter and lost $3 million, you wouldn’t even talk about it,” he explains patiently. “That’s what this was. We didn’t even lose money this quarter. We earned $5 billion. The analysts estimate us having a record year.”

“We’re still pleading guilty to being stupid and dumb, though,” the PR guy sitting next to us interjects.

“It was the dumbest thing I have ever seen,” Dimon concurs. “It was so complex, so large, so illiquid, so stupid. It didn’t get the rigor that it should have entailed.” The woman in charge of the Chief Investment Office, Ina Drew, had been with the company three decades. Dimon says he was urged to hang her out to dry. “I felt terrible for her. I said, ‘Guys, that could be your mother. You want me to treat your mother that way?’?” He accepted her resignation nonetheless, though it did not stop people from calling for his own.

Dimon knows what the next question is. “Did I ever consider resigning?” he asks preemptively. “No. People and companies make mistakes. I guarantee we’ll make a mistake next quarter. So what? Businesses make mistakes. Hopefully smaller, and fewer.”

Compounding his headaches, JPMorgan also recently disclosed that its records had been subpoenaed as part of the wide-ranging LIBOR investigation. And then there was Weill, Dimon’s mentor turned rival, who opened up a new can of worms when he appeared on CNBC last month with a fresh-off-the-yacht tan to lay the blame on the business model he and Dimon pioneered together. “What we should probably do is go and split up investment banking from banking,” he said, almost impishly.

At the mention of Weill, Dimon’s lips shrink into a hard line. He won’t address the CNBC appearance, or speak about Weill at all. “There are huge benefits to size,” he says instead, a distinct air of tired-of-this-shit creeping into his voice. “We bank Caterpillar in like 40 countries. We can do a $20 billion bridge loan overnight for a company that’s about to do a major acquisition. Size lets us build a $500 million data center that speeds up transactions and invest billions of dollars in products like ATMs and apps that allow your iPhone to deposit checks. We move $2 trillion a day, and you can see it by account, by company. These aren’t, like, little things. And they accrue to the customer. That’s what capitalism is.”

He takes a breath. “The whole world has become crazy. Businesses get attacked every time they do something.”

He’s being hyperbolic, but at the same time, the sense of menace is very real. Over the past several years, Dimon has received numerous death threats, and I was told when setting up this interview that it couldn’t occur outside the office for security reasons. (The need for bodyguards appears to offend his masculinity as well as his sense of justice.)

“Everyone is talking about the culture, the culture, and all that, and it’s just not true,” Dimon says. “Most bankers are decent, honorable people. We’re wrapped up in all this crap right now. We made a mistake. We’re sorry. It doesn’t detract from all the good things we’ve done. I am not responsible for the financial crisis,” he adds. “I hate to tell you. We were a port of safety in the storm. I find it unbelievable that that is the general theme—that you have to walk in a room and act like you are responsible for things you are not responsible for.”

He’s staring into the middle distance as he says all of this, as if addressing an invisible, unpersuadable audience. But when I ask if this episode has made him regret being such an outspoken defender of the banking industry, he looks at me point blank. “I’m an outspoken defender of the truth,” he corrects me. “Everyone is afraid of retaliation and retribution. We recently had an event with a hundred small bankers here, and 85 percent of them said they can’t challenge the regulation because of the potential retribution. That’s a terrible thing. Okay? This is not the Soviet Union. This is the United States of America. That’s what I remember. Guess what,” he says, almost shouting now. “It’s a free. Fucking. Country.”

July 13 (Bloomberg) — Warren Buffett, the billionaire chairman of Berkshire Hathaway Inc., talks about JPMorgan Chase & Co.’s $4.4 billion trading loss at its chief investment office and the U.S. banking industry. Buffett also discusses his investment strategy and holdings, the U.S. economy and housing market, and the outlook for the euro. He speaks with Betty Liu at the the Allen & Co. media conference in Sun Valley, Idaho, on Bloomberg Television’s “In the Loop.” (Source: Bloomberg)

Confessions of a bargain hunter

In the offices of an unmarked high-rise building in Boston sits Seth Klarman, surrounded by stacks of papers and books, which, by his own admission, are at risk of toppling over and crushing him at any instant.

Klarman is the founder and president of the phenomenally successful Baupost Group, a $29 billion ”deep value” hedge fund. It has produced 19 per cent annual returns, and every $10,000 given to Klarman at inception in 1982 is worth about $1.85 million today – and this was achieved while carrying extremely high levels of cash (more than 50 per cent at times) and using minimal leverage.

So how did he do it?

Know your seller

The financial markets are fiercely competitive, with millions of investors, traders and speculators around the world trying to outwit one another. Klarman concluded that since prices are set by the forces of supply and demand, rather than buy something and wait for someone to demand it at a higher price, why not wait for an irrational supplier to sell it to you for any price? Hence, Klarman looks for assets that people are being forced to sell or avoid, often as a result of fear or institutional constraints.

You can apply this principle by looking at heavily sold or avoided opportunities closer to home.

For example, stocks at the bottom of the S&P/ASX 200 are kicked out and replaced on a regular basis and, since index funds can hold stocks only over a certain size, newly removed stocks from the S&P/ASX 200 are sometimes driven down in price because of the selling pressure from such funds.

To make matters better, owing to regulation many super funds often cannot invest in smaller companies and such stocks are rarely followed by analysts. Servcorp resides on Intelligent Investor’s buy list and falls into this category.

Some institutions are also forced to ignore debt instruments unless they achieve a certain credit rating, even though they might offer an attractive risk-reward profile. You can take advantage of this by investing in income securities in a downturn, when large price falls create great opportunities such as those in 2009, for example, the Goodman PLUS, Dexus RENTS and Southern Cross SKIES hybrid securities.

Tax-loss selling (in Australia, this tends to occur in June, at the end of the financial year) can cause irrational mispricing in already beaten-down stocks. Cheap blue chips that could be this group next week include Computershare, QBE Insurance and Macquarie Group.

Competitive advantage

The difference between great investors and mediocre ones is only a few percentage points in terms of judging things correctly. Klarman realised he would have to bring something different to the game to win: a ”competitive advantage”.

”I will buy what other people are selling,” Klarman says. ”What is out of favour, what is loathed and despised, where there is financial distress, litigation – basically, where there is trouble.”

An inexperienced individual will have little success using such a tactic. After all, how many of us have four years to spend analysing Enron’s accounts? Instead, look for inefficiencies you can exploit.

Most market participants have a narrow, short-term view and are driven by fear and greed. So your edge is having a longer-term perspective and controlling your emotions. These two advantages will help you pile on the performance points over the professionals. Both have been invaluable to Klarman.

Cash is a weapon

Holding cash is perhaps Klarman’s most famed characteristic.

However, contrary to what you might expect, Klarman holds cash so it can be used in a concentrated manner when the right opportunity arises. This is because while value investing outperforms in the long run, Klarman quips that ”you have to be around for the long run … [you have to make sure] you don’t get out and you are a buyer”.

Despite the complexity of some of his investments, Klarman’s underlying approach is not complicated, although that is far from saying it is easy.

He says Baupost has outperformed ”by always buying at a significant discount to underlying business value, by replacing current holdings as better bargains come along, by selling when the market value comes to reflect its underlying value, and by holding cash … until other attractive investments become available”.

Nathan Bell is the research director at Intelligent Investor, intelligent investor.com.au. This article contains general investment advice only (under AFSL 282288).

As the Article 78 proceeding challenging New York’s approval of buy-rated MBIA’s 2009 split enters its third week, three questions arise: what remains of the proceeding, when is it likely to conclude, and who is likely to win?

Since the Article 78 pre-trial hearing on April 20, New York State Supreme Court Justice Barbara Kapnick has made it clear that she does not consider the proceeding to be a full-blown trial, but rather a “glorified oral argument” with some witnesses. While Sullivan & Cromwell’s Robert Giuffra, the attorney for Bank of America (BAC) and Societe Generale, has argued from the outset that disputed issues of fact warrant a trial, Kapnick has continued to assert that such an approach was not necessary for the purposes of resolving an Article 78-related dispute (one in which a decision by a New York state agency is appealed).

So after Giuffra opened the proceeding with four days of argument and David Holgado, the attorney representing the Department of Financial Services (DFS), followed with another two days of argument, Marc Kasowitz of Kasowitz, Benson, Torres & Friedman, representing MBIA, began his argument on Thursday, after which court was adjourned until today at 10am. We believe it is likely that Kasowitz will wrap up his argument later today.

What’s next? We know with certainty that both sides will have an opportunity to rebut each other’s arguments, which should take at least a couple of days. (Given Giuffra’s propensity for lengthy and detailed discourse – he has clearly conducted his argument as if the proceeding was the full-blown trial he desires – investors may be wise to take the over on duration.) We also know that Kapnick has said from the beginning that she wants two witnesses to testify: Eric Dinallo, who as Superintendent of the New York Insurance Department (NYID) – the DFS’s predecessor agency – approved MBIA’s split in Feb-09, and Jack Buchmiller, an NYID analyst who reviewed the split after it was proposed. While Kapnick appeared inclined to confine the witness list to those two, she also said she would decide later whether additional witnesses would need to be called.

Given the already holiday-shortened week, the fact that Kapnick has used the past two Wednesdays to attend to other cases, the fact that Kasowitz still needs to conclude his argument, the potential testimony of at least two witnesses, and rebuttals of unknown duration, we believe it is likely that the proceeding is likely to extend until next week. At that point, Kapnick will be in position to rule on the case.

Who is likely to win? Kapnick has been consistent from the onset of the proceeding in asserting that under Article 78 the sole question to be answered is simply whether the NYID had acted in an “arbitrary and capricious” manner when it approved MBIA’s split.

During the pre-trial hearing, when Giuffra was doing his best to expand the scope of the proceeding to questions about whether MBIA had concealed vital information from the NYID during its review prior to the split – and even questions about the fairness of the split and whether the transfer of $5bn to a newly created municipal bond insurance business had constituted a fraudulent conveyance – Kapnick remained steadfast in keeping the focus of the proceeding on the rationality of the NYID’s decision. “This case is really, really directed towards the actions of the Insurance Department in approving this transaction,” Kapnick said. “It’s not a case about all these terrible intentional things, about concealing, [that MBIA is accused of having done].”

When the proceeding began on May 14, Kapnick continued to keep the focus on the NYID’s rationality in her initial instructions to Giuffra: “Start by presenting to me your case, based on the record that we already have, as to why you think the determination by the insurance department was arbitrary and capricious.”

Giuffra then proceeded to spend much of the next four days focused on how the NYID had collected the various inputs that Dinallo had been provided before he approved MBIA’s split, as well as the various potential inputs that Dinallo never saw because the bond insurer had allegedly concealed them from Buchmiller during his review. All of these efforts by Giuffra and his partner, Michael Steinberg, were aimed at one goal: to change the standard of review of the case. Giuffra and Steinberg want Kapnick to apply a “fair and equitable” standard under which the question would be whether Dinallo could have made a rational decision about MBIA’s split if the inputs he used in his deliberations were inaccurate or incomplete due to the company’s supposed errors and omissions. “If the facts were wrong, the arbitrary and capricious standard does not apply,” Giuffra said. “In fact, it shifts and the decision should be annulled.”

We can understand why Giuffra would employ this strategy, because if the standard remains whether the NYID had been “arbitrary and capricious” it is a very low bar for the defendants to overcome. Moreover, New York courts have historically given significant deference to the decisions of state agencies. Simply stated, if “arbitrary and capricious” is the standard, we believe it is highly likely that MBIA will win.

So will Kapnick stick to the “arbitrary and capricious” standard, or will she be persuaded by Giuffra to change it? We have neither heard nor seen any indication from the judge thus far that she will do so. And we agree with Kasowitz’s assessment of Holgado’s argument: “I think it’s difficult to come away from Mr. Holgado’s presentation with any conclusion other than that the banks cannot come close to meeting the heavy burden of demonstrating that the [NYID's] approval of the transformation was arbitrary and capricious.”

If we were to incorporate what we have gathered from Kapnick’s body language and attitude into our effort to handicap the proceeding’s outcome, it would support the views of those who believe Giuffra is playing for the appeal rather than the win. (One problem with that approach: Kapnick’s rulings are rarely reversed on appeal.) Since the pre-trial hearing, Kapnick has often appeared annoyed with Giuffra, who has done little to ingratiate himself with the judge. (Our favorite episode occurred during the pre-trial hearing when, as part of his argument that a full-blown trial was warranted, Giuffra began to explain to Kapnick what a trial entails. Kapnick, who has served as a judge for 21 years, told the attorney that she is well aware of what a trial is.) We believe Kapnick has given Giuffra considerable latitude during the proceeding – including allowing his argument to extend for four days – to make her handling of the case more defensible on appeal.

And that’s before taking into account any impact from the announcement on May 16 from two New York State Senators that they could open an investigation of whether MBIA concealed information from the NYID, with the implication that an inquiry would be initiated if Kapnick didn’t find in the banks’ favor in the Article 78 proceeding. While Kapnick ruled against MBIA’s request for discovery on the matter, Giuffra never explicitly denied that anyone on the banks’ side had encouraged the senators to issue their announcement. While both sides said they were comfortable that the episode wouldn’t influence Kapnick’s decision in the case, we have to believe that an apparent effort to manipulate the proceeding in her courtroom would make her feel a tad grumpy toward the banks, if only on a subconscious level.

Bottom line: We believe Kapnick will rule in MBIA’s favor.

So if MBIA wins, what does it mean? First of all, we do believe an MBIA victory will increase the likelihood of a settlement with BAC (and SocGen, which we believe is riding BAC’s coattails) in the near future. Even if BAC’s strategy is to drag out the case until MBIA Insurance runs out of cash in mid-2013, or to knock out the bond insurer in the plenary action also scheduled for next year, we question whether it would be in the bank’s best interest to expose itself to the various potentially negative developments that could occur before the end of this year.

Imagine that you are BAC CEO Brian Moynihan and you’re reading the headlines about MBIA prevailing over BAC in Article 78, which may embolden the many, many mortgage-backed securities (MBS) holders who believe they were wronged by Countrywide and now want to be compensated by the bank for their losses. Your side took a shot at delivering a major blow to MBIA, which continues to refuse the low-ball settlement offer you made last July (as reported by Bloomberg), asking for a figure closer to $3bn. Now, you won’t have another opportunity to defeat the bond insurer in court for some time, as the potential Article 78 appeal is months away and the ABN Amro v. MBIAplenary action won’t take place until 2013.

In the interim, MBIA presents a clear and present danger to your franchise on several fronts. The bond insurer was one of the first to seek damages from Countrywide when it sued the lender in Sep-08, and among the first to see its case reach a courtroom. Behind MBIA is a long and growing list of plaintiffs who are in much earlier stages of their cases against BAC.

Two of the main defenses BAC has used thus far involve causation and successor liability. In the former, BAC has argued that while there may have been breaches in representations and warranties (R&W) in Countrywide mortgages, there is no proof that the losses incurred by MBS investors were caused by the breaches rather than the credit crisis. New York State Supreme Court Justice Eileen Bransten ruled in MBIA’s favor on this issue on Jan. 3 in MBIA v. Countrywide, but her decision was a partial summary judgment for the bond insurer such that it would be allowed to identify R&W breaches and tally the losses. Still, MBIA strategically cross appealed Bransten’s ruling because if it receives a full summary judgment on appeal, that ruling would apply to other MBS investors as well. If this were to occur, it would be no picnic for BAC – the approximately $16bn reserve the bank has posted against its R&W liabilities could balloon to $80bn or more. The appellate court, which will not hold a hearing on the matter but instead will decide it based on filings, could rule at any time. If we were to apply the same timing as occurred the last time the appellate court ruled on one of Bransten’s decisions – exactly six months – then the court could rule in early June.

Successor liability was the defense that BAC successfully used against Allstate earlier this year, as the bank argued that it never actually merged with Countrywide – it claims the transaction was structured as an asset purchase – and therefore is not liable for the losses associated with the lender’s R&W breaches. While this defense worked with U.S. District Court Judge Mariana Pfaelzer, who in February used Delaware law in making her determination in the Allstate case (which is being appealed), New York law will be applied in MBIA v. Countrywide. Delaware law sets a high bar for determining if a transaction was a de facto merger, while New York has a significantly lower bar. (In a stock-for-stock transaction such as BAC-Countrywide, evidence of integration activity is all that is required by New York law to demonstrate that a de facto merger had occurred.) The MBIA case could damage BAC’s chances of successfully employing the successor liability defense in other cases if Moynihan’s deposition provides fodder – he had been quoted in the media as saying that “At the end of the day, we’ll pay for what Countrywide did” – or if Bransten makes precedent-setting rulings in advance of the trial, which is slated to begin in 2013.

Meanwhile, MBIA continues to collect information during the discovery process in advance of MBIA v. Countrywideabout both the lender’s R&W breaches and its alleged fraudulent activity that could be used by the many other parties suing BAC to significantly accelerate their own cases against the bank. Given our belief that BAC’s strategy for managing its R&W exposure is predicated on spreading its outlays over time so it doesn’t take too much of a hit to its capital within a narrow timeframe, we think as long as MBIA’s information is subject to subpoena it represents a material threat to BAC’s plans.

Toss in the fact that if those objecting to the $8.5bn settlement between BAC and Bank of New York as trustee for 530 trusts prevail in the upcoming Article 77 proceeding and scuttle that agreement, it will create hundreds of new mortgage-putback cases against BAC. This time, the trusts will be looking for much more than the few pennies on the dollar they received in the original settlement, and they all would benefit greatly in their efforts if they had the information about Countrywide that MBIA possesses.

Hence, we continue to believe it would be imprudent for BAC to imperil the interests of its shareholders and employees by continuing to avoid a settlement with MBIA. In our view, it is a calamitously bad decision for a bank with $3.2tn in assets and a market capitalization of $77bn to expose itself to an accelerated death by a thousand cuts from umpteen plaintiffs when it could manage the timing of that litigation and avoid some ugly rulings and precedents by simply writing a check to MBIA. And BAC could even benefit by doing so if it (like Morgan Stanley in announcing its settlement with MBIA) trumpets the advantages of the settlement to the bank from a capital standpoint in advance of Basel III. Thus, Moynihan could turn a pig’s breakfast into a win-win.

One-hundred billion dollars is a very dear price to pay for Facebook stock and IPO participants clearly have extraordinary expectations about Facebook’s future prospects. Companies that are heavily promoted, wall street favorites, never sell for bargain prices and Facebook is no exception. Paying such a dear price places your ultimate outcome on events in the distant future. People assume that they will make money if Facebook’s current prospects materialize, but this is completely wrongheaded; you gain nothing from the development of current prospects, because you over paid. Your results depend on a future set of outcomes which are completely unknown and unknowable.

In much the same way as it is possible to profit from gambling in Las Vegas, it is also quite possible to profit from buying Facebook at $100 billion, but be forewarned, this sort of commitment is not an investment-it is most definitely speculation with concomitant risks.

Advice From a 105-Year-Old Banker

As markets gyrate wildly, Irving Kahn, who at 105 is perhaps the world’s oldest investment banker, says not to worry—the economic downturn is just a blip.

The stock market is imploding, Europe is on the brink, and, if the doomsayers are to be believed, we could be headed for a double-dip recession.

None of that worries Irving Kahn, perhaps the world’s oldest working investment banker. “There are a lot of opportunities out there, and one shouldn’t complain, unless you don’t have good health,” says Kahn. At 105, he might well be the last man on earth who can speak authoritatively on both longevity and making money amid a historic market meltdown. In 1928, at the age of 23, he went to work on Wall Street as a stock analyst and brokerage clerk. By the tail end of the Great Depression, in 1939, he’d made enough money in the market to move his wife and two children out of public housing and into their own house in the suburbs.

Kahn is still in the game, waking every morning at 7 and going to work as chairman of Kahn Brothers, the small family investment firm he founded in 1978. Until a few years ago, he took the bus or walked the 20 blocks from his Upper East Side home to his midtown office. “For a 105-year-old guy, it’s pretty remarkable,” says Thomas Kahn, Irving’s 68-year-old son and the company’s president. “I get tired just thinking about it.”

Perhaps his closest rival for the title of oldest person working in the securities industry was the financier Roy Neuberger, who passed away in 2010 at the age of 107. But Neuberger had retired at 99. Two of Kahn’s older sons, both in their mid-70s, have likewise retired.

Small and gnomish, Kahn counsels patience in hard times as he holds forth on market distortions and the roots of economic unrest, which he pins on “a bunch of gamblers going crazy on the floor of the exchange.” “Wall Street,” he adds, “has always been a very poor judge of value.”

“This may surprise you, but there were a large number of valuable buys during the Depression.”

The depths of the Depression turned out to be a useful time to learn that lesson. At Columbia Business School, Kahn served as an assistant to economist Benjamin Graham, the value-investing guru whose principles of caution and defensive investing inspired a cadre of disciples that includes Warren Buffett. It’s an investment strategy born of the beating Graham had taken in ’29, and Kahn adopted it as his own. “I stopped wasting time on what people claimed a stock was worth and started looking at the numbers,” he says. “This may surprise you, but there were a large number of valuable buys during the Depression.”

Then and now, he says, the smart money was on companies with sound fundamentals. “You always had a long list of what I’d call legitimate businesses,” he says—the ones that produced food, clothing, and other essentials. “Everybody still wanted a clean shirt. They wanted to buy Procter & Gamble.” A science buff, Kahn also grew adept at spotting the long-term potential of emerging technologies and new industries. In the 1930s, that meant radio and movies, both of which boomed despite the downturn. Today he’s apt to talk up environmental and energy startups. “You have to have a certain amount of cultural interest in technology to be early in the field,” he says.

Life for a Depression-era Wall Streeter was markedly frugal by current standards: Kahn and his wife, Ruth, enjoyed a penthouse apartment in public housing—the Knickerbocker Village complex on Manhattan’s Lower East Side. “My kids were brought up as if they had a wealthy father, which they didn’t.” He’d walk home for lunch, to save money on restaurants. Kahn’s fortunes improved as the Depression wore on: by 1939 he was doing well enough to buy a house in Belle Harbor, Queens, and he later prospered as the director of several companies, including the Grand Union supermarket chain.

But his habits have remained exceedingly modest. “Irving’s a funny guy,” Thomas Kahn says. “He doesn’t play golf, there’s no weekend house, no country-club membership.” For years he ate the same dish—chopped steak, rare—at the same time-worn French restaurant, Le Veau d’Or, on the Upper East Side. He traveled only reluctantly, at the urging of his wife, and would haul stacks of annual reports to read on Caribbean vacations. Ruth died in 1996, after 65 years of marriage, and Wall Street became his main companion. “I couldn’t find another person or occupation that had as much interest for me as economics,” he says.

For the past several years, Kahn’s longevity has been the subject of scientific inquiry: he’s participating in a study of centenarians at the Albert Einstein College of Medicine in the Bronx, by geneticist Nir Barzilai. Barzilai hypothesizes that Kahn’s extraordinarily high amounts of “good” HDL cholesterol are exerting some protective effect, warding off age-related infirmities. It just might be luck, a genetic gift that he shares with two centenarian siblings, including an older sister of 109 and a younger brother of 101.

Thomas Kahn seems convinced that the market itself is keeping his father alive. Indeed, watching indexes gyrate offers the elder Kahn endless diversion. “I get a kick out of seeing who’s going to come out ahead in this race,” he says.

This is one of the gifts of age, scientists say—the ability to focus on the bright side of things, a talent that Kahn displays in abundance. If you can believe him, happy days will be here again.

“I’m a great bull on American democracy,” he says. “If you give me a long leash on this dog, I can hold him at bay.”

If this downturn culminates in an actual depression, says Kahn, it will end more quickly than the one he endured as a young man, because technology will somehow turn the economy around. “Sometimes favorable surprises come out of the blue.”

A breakout session led by Professor Bill Sahlman Tuesday, October 14, 2008
This panel of experienced investors discusses the U.S. financial crisis and its causes, as well as potential investment opportunities.

HBS Interview with Seth Klarman, MBA 1982
An interview with HBS alumnus Seth Klarman regarding his experience at HBS and his views on leadership and success and the priority of giving back to one’s community.
Seth Klarman, MBA 1982

Mac Greer: Roger, we recently spoke with Alice Schroeder and we asked her what she thought the most underrated and the most overrated aspects of Warren Buffett’s success were, so I want to put those same questions to you. First of all, what do you think the most underrated part of Buffett’s success is?

Roger Lowenstein: The most underrated part of his success would be his independence of character, his ability to just not do what everyone else is doing, to stand apart from it … just not to be affected by it and not swing at pitches he is not sure about. How many times have we heard he’s through? We heard that in the dot.com era and we heard it in the mortgage era again. Just bubble after bubble, he stands on the sidelines and lets other people take what seem to be easy gains until they come crashing down. It sounds easy in retrospect, but it just takes an awful lot of self-confidence.

Greer: And what do you think the most overrated part of his success is?

Lowenstein: The most overrated part of his success, his connections, the supposed advantages that some people say he has because of his connections. I don’t think he really is overrated. He started with essentially nothing. Just through picking stocks and then as he got bigger, picking companies, never taking options or quick ways to personal fortune. Geez, how can you say any of that is overrated?

Greer: When I asked Alice, she said the underrated piece was just how hard he works — people just don’t understand how hard he works at it.

Lowenstein: That’s good.

Greer: And in terms of overrated, she said that people attribute so much of his success to stock picking, but she really made the point that so much of his success came through choosing companies and businesses to buy and then really striking favorable deals and as she said, being “somewhat predatory.” So with all that in mind, given the fact that most individual investors can’t command those terms, we don’t have the leverage, of course, that Buffett has. What is the most important thing that every investor can learn from Buffett and apply?

Lowenstein: If you look at the stocks that made him, The Washington Post (NYSE: WPO) was selling at four times earnings; anybody could have bought it. Same thing, the ad companies, same thing Coca-Cola (NYSE: KO) back when he bought it in the eighties. Just on and on and on. He didn’t get a special deal on Burlington Northern recently. He didn’t get a special deal when he went into the insurance business, but he sure does have the insight, intelligence and the courage to not write insurance policies when the premiums are too low, which is essentially the mistake that AIG (NYSE: AIG) made.

I think you should learn from Buffett these simple lessons that he keeps talking about. Alice and me and other Buffett writers have written about — stick to stuff you know. If something is going up and other people are buying it, but you don’t understand it, let that go by and buy something you would be confident for holding for three, four, five years. Don’t buy on the basis of it’s going to go up tomorrow or someone else is going to take it off your hands, but that if you were buying the whole business at that price, you would be happy owning and operating that business, having put that amount of capital on a per-share basis in. You can’t go wrong doing that kind of stuff.

Greer: Roger, I was struck in terms of that “sticking to what you know.” Buffett doesn’t just apply that to investing, he also applies it to how he gives away his money, and it really struck me a few years back when he essentially said, “The Gates Foundation knows a lot more about how to best give away my money, so I am going to put them in charge of it.”

Lowenstein: That’s right. He had his career in investing. He shied away from the “own a little bit of 100 different stocks” approach. He said look, I am going to find a few where I can, where I really have an edge in terms of knowledge and in terms of insight, whatever, and go big in them. He wanted to do the same thing with his philanthropy. Instead of giving a little bit to a zillion causes, all of which probably are good and well meaning and so on, he wanted to say, where can [I put] my dollars now, and after I am gone, make a difference?

So he was lucky enough to have a friend, Bill Gates, who is a billionaire in his own right and philanthropist and he is younger and therefore has a life expectancy that he should be around for 20, 30 years longer than Buffett and is tackling a cause which is basically world health that Buffett believes in. So instead of trying to find 30 little Bill Gates just to replicate that, he said, bingo, I have got my man. He was willing to say, OK, there will be no Warren Buffett entity trolling around in Africa giving redounding glory to Warren Buffett, but the idea is maybe he can help more Africans and others in world health that way. So that is what he did.

There appears to be a negative reaction to Buffett’s recent support of Moody’s during his testimony to the FCIC.

In response to a question about what remedies might prevent future conflicts of interest, given the quality of the information provided by Credit rating agencies (CRAs) and the means by which they are compensated, it would appear to me as though there is only one true remedy. Investors must determine for themselves whether an investment makes financial sense. Insofar as professional investors should be concerned, the usefulness of these agencies should not extend beyond a secondary or tertiary assessment of investment risk with which to compare against one’s own assessment of risk. If I as an investor need to rely on a third party’s assessment of investment risk, I should not be in a position to allocate money on behalf of other individuals or institutions. (I fully recognize the role of these agencies in relation to, for example, the investable securities of insurance companies. Statistically, such requirements provide more benefit than they do harm.)

Ultimately, decisions based upon someone else’s set of facts (without independent verification) in my opinion, deserve to fail and should fail on the basis of meritocracy.

Individual Investors and Professional Money Managers Suffer From the Same Basic Defect

Individuals fail to identify the best money managers for the same underlying reasons that most money managers are unable to identify the best investments, which to a large extent is a problem of perception and a lack of relevant knowledge. The set of tools (education, personal experience through trial & error, etc.,) that individuals acquire over time generally allow them to make sensible everyday decisions. So much so, our brains create shortcuts in the decision making processes, which work well when faced with simple problems. For example, how to decide where to eat when out of town? If you’re like me (i) you ask someone, (ii) you select at random-though usually a familiar restaurant chain, or (iii) you look for the largest crowd. You generally can’t go wrong eating at a crowded restaurant or somewhere familiar. These are pretty good mental models as they relate to restaurant selection and the result is an easy one to measure because it’s immediate and isn’t ongoing. Moreover, you can’t improve taste, because taste is a matter of opinion.

However, the mental shortcuts that help us pick a good restaurant, hinder our ability to consider the relevant facts when the facts relate to a complex system. When faced with complex decisions, we run into problems because we lack a natural mechanism with which to consider current decisions as they relate to ongoing future outcomes. It’s important in this case to recognize when you’re outside your circle of competence. One common solution is to seek-out an expert adviser, but this only turns an old problem into a new one. Now you have to select an able and competent adviser.

With Respect to Money Management
Outsourcing investment decisions is the only option for most people without time or interest to invest properly. But when selecting someone to oversee your hard earned money what criteria do you consider? The first item that often comes to mind is experience, however, this concept may be to your ultimate detriment.

The Validity of Experience
In many aspects of life there is a positive correlation between length of time performed and competency. That is, people tend to follow the general premise that having done something with a greater frequency or for a greater length of time makes an individual more qualified, better skilled, and more knowledgeable. This rule of thumb may be reasonable some of the time, but it is not universal. Human nature being what it is, often causes us to base decisions upon habit not reason. In the investment management business, the validity of experience as qualified simply by an act of having done something with greater frequency or for a greater length of time is unfounded. The flaw is in the assumption that investing over time provides the individual with an increased knowledge of the subject. But what can be said about the merit of knowledge based upon the wrong set of facts, truths, or principles?

Performance & Knowledge
Selecting a good money manager may appear as though it’s simply a matter of selecting a smart money manager with a good investment record since, ultimately, investment knowledge and investment performance eventually converge, but they don’t necessarily converge right away. In some (often many) cases, an investor may possess the correct knowledge, but performance lags. In other cases, an investor may initially perform well, but may not understand that his returns were akin to gambling, leverage, or both-which means the knowledge they possess is incorrect. Over longer periods of time performance records are very useful in measuring the merit of an investor, but to a much lesser extent when the record is less then 10 or 15 years long. Gauging performance is a very big problem for the average investor, but also for many investment professionals. Investment performance should be measured with respect to the money managers systematic approach i.e. what the money manager is doing and why they are doing what they are doing. Equally important, the money manager must be able to clearly identify and explain why their investments turn out well or poorly.

Let’s review the performance of one fund from 1991 through 2001 relative to the S&P 500:

Annualized Returns 1991-2001
Baupost 12.83%
S&P 500 15.25%

Baupost is run by Seth Klarman, whom I believe is one of the worlds top 5 investors. However, many individuals would be unimpressed by his record through 2001 and therefore uninterested-at the time-in investing with Baupost, because he underperformed the market-but in my opinion, the more important question was why he underperformed? From 1991-2001 his fund underperformed the market because he looked around and said to himself, people are crazy, prices are inflated, and there is little out there we find compelling. He therefore simply said we’re going to hold cash until things change. In 1997, 25% of Baupost’s portfolio was cash. By the end of April 2001, nearly 50% of Baupost’s entire portfolio was cash. This explains largely why Baupost underperformed. The proportion of the portfolio held in cash earns almost no interest, which drives down the overall portfolio’s return, but at the same time the value of cash is not subject to market fluctuations. Though he underperformed for 10 years, when the tech bubble blew up, Baupost had plenty of cash to take advantage of cheaply priced securities and as a consequence hugely outperformed since 2001 and therefore also since inception. It would have made as much sense to invest with Seth and Baupost in 1991 as it would now. Having only looked at performance, you would likely not have invested in Baupost.

All investors (both know-nothings and know-somethings) want to make optimal, rational investment decisions, but rarely do. Some do well strictly from the law of large numbers, e.g. if enough people throw a dart some will get pretty close to the bulls-eye, but not all are skilled. This hurts investors that are looking at performance numbers, strictly. Moreover, it is commonplace for most people to assume that if a person of business is wealthy he is wealthy because he was or is a good businessman (or has good business sense), but this is also wrong-headed. It is critically important to separate out those who do well by chance and those who do well for identifiable (often repeatable) reasons. Unfortunately it is hard to correctly identify a know-nothing businessperson from a know-something businessperson, if you either know nothing about business or are otherwise a know-nothing business person.

If, as a money manager, you are unable to identify how much an asset is truly worth and disciplined enough to only pay a reasonable price for it, then you will not earn above average returns. If, as in individual investor, you are unable to identify a money manager with such knowledge, then you will not earn above average returns either.

The point of this rather elaborate discussion is that good investors are easily identified by good businessmen (smart private business owners) because good investors are good businessmen. By definition, this means that individuals are likely to employ the wrong mental model when selecting their money manager. It also means that your money manager is similarly likely to employ a flawed mental model when making investment decisions. As with all solutions to adult problems, nothing worthwhile in life comes easy. Fortunately, the average individual is perfectly able to learn the right questions to ask and to be well enough informed to make sound investment decisions, but you need a good foundation based upon good information. There is no single right answer, but there is a single book that will help the average investor make sensible investment decisions. The intelligent Investor, written by Benjamin Graham is still by far the best book ever written. Graham provides a road-map of the proper way to think about investing. The intelligent Investor is not the final answer, but it’s a start.

Keep in mind the best investors didn’t alter their approach midway through their career. Either you get it right from the start, or you never get it at all. If a money manager has a long track record, look at their track record, it’s important. If a money manager has little or no track record, don’t pay too much attention to performance, good or bad. It’s not that performance is unimportant, but it’s not all-important when the record is short. In either case, spend plenty of time trying to understand how they think about business. (You’ll find a few tips further below.) Also, before investing with any money manager, meet with them. Take some time beforehand and create a checklist of questions to ask and answers to expect.

Helpful Hints

A Few Questions to Ask:

What’s the money manager’s goal/objective & How do you think about risk?

Worrisome answer
Be wary any time you hear terms like risk profile, beta, alpha, optimal portfolio, volatility, or other terms sounding Greek/foreign. Don’t take any advice blindly, including mine-have them explain any term that you don’t completely understand. If it still doesn’t make sense to you, you’re probably correct, it doesn’t make sense.

Reasonable answer
Objective is to avoid permanently losing capital while earning an attractive return. In the broader sense, risk is the potential for long-term capital loss.

Reasonable answer
Select common stocks that they believe are undervalued at the time of purchase. Views common stocks as units of ownership of a business. Do not place any merit on technical stock market studies, specific sectors, trends, or generally fashionable securities. Significant time is spent looking at the balance sheet, earnings history, and prospects of each investment to appraise underlying business or investment value.

How the money manager you determine whether their investment decisions were good or bad?

There is only one answer to this question.
The logic at the time of initial investment must be consistent with the reasons for any change in the value of a securities value over a reasonable period of time. A reasonably correct and thorough answer isn’t easily identified, which is why you need to do a little homework before making these important decisions. Again, I recommend Ben Graham’s, Intelligent Investor available at any local library or book store.

How much of the money managers net worth is invested in the fund/partnership?

Don’t feel uncomfortable asking this question, it’s completely reasonable and a common question asked by smart investors. If the large majority of their money won’t be invested alongside yours there better be a really, and I mean really good reason. Anything less than 60% is a bad sign.

1HOW OMAHA BEATS WALL STREET
Forbes discovered Warren Buffett in 1969, and this early interview
introduced the iconic investor to a wide audience for the first time.

4THE MONEY MEN
Look At All Those Beautiful, Scantily Clad Women Out There!

6“YOU PAY A VERY HIGH PRICE IN THE STOCK MARKET FOR A CHEERY CONSENSUS”
What does Buffett think now? In this article written for
FORBES he puts it bluntly: Now is the time to buy.

8WILL THE REAL WARREN BUFFETT PLEASE STAND UP?
Warren Buffett talks like a cracker- barrel Ben Graham,
but he invents sophisticated arbitrage strategies that keep
him way ahead of the smartest folks on Wall Street.

12WARREN BUFFETT’S IDEA OF HEAVEN: “I DON’T HAVE TO WORK WITH PEOPLE I DON’T LIKE”
Warren Buffett this year moves to the top of The Forbes Four Hund red.
Herein he ex plains how he picks his uncannily successful investments and
reveals what he plans on doing with all that loot he has accumulated.

29THE BERKSHIRE BUNCH
Chance meetings with an obscure young investment counselor
made a lot of people wildly rich. Without knowing it, they were
buying into the greatest compound-interest machine ever built.

33A SON’S ADVICE TO HIS FATHER
Howard Buffett does not expect to inherit his dad’s place on
The Forbes 400, but he hardly seems bitter.

36 A WORD FROM A DOLLAR BEAR
Warren Buffett’s vote of no confidence in U.S. fiscal policies
is up to $20 billion .

Appraisal of General Motors Common Stock
by Nicholas MolodovskyThe Analysts Journal 1959

THE THEORETICAL INTRINSIC VALUE OF GM for 1959 is estimated in this report at 52. With the stock currently selling around 50, its price is almost in line with value. However, GM is not the only stock in the market. The advantage of the method used in this study is that it allows setting up comparative tables for an unlimited number of equities, in terms of today’s values as well as of values projected into future years. An investor can select the most undervalued stocks for the time range of his planning. And these appraisals are entirely independent from the past or present prices of the stocks in question.

As The Analysts Journal is the professional forum for the National Federation of Financial Analysts Societies, it would be improper to use its pages for selling specific stocks. However, we can justify the selection of an equity which is fairly valued by the market for illustrating the practical application of proposed principles of appraisal.

Introductory Notes
In an address reprinted in The Commercial ~ Financial Chronicle of October 30, 1958, an appraisal of the Dow Jones Industrial Average was based on a technique of valuation gradually developed through years of work. This DJIA study was begun at the end of July, when the Average had crossed 500. The address was delivered when it stood at 535. It was then a representative opinion that the market had broken loose from traditional moorings of price-to-earnings and yield ratios and was dangerously high. The conclusion that the DJIA was still reasonably priced at that level seemed more daring last October than it does in retrospect now in May. The methods and techniques used in the DJIA appraisal were described in a 20,000-word article published in the February issue of this Journal. Written primarily for professional analysts, it found good response outside their specialized ranks. Fortune magazine mentioned the methods and techniques last month in an article on growth stocks. In April, 1958, a comprehensive valuation report on GM was sent to many analysts with request for comments on the method of appraisal. The stock was then selling at 35.

The report estimated GM’s 1958 theoretical intrinsic value at 45 and recommended purchase. The present study offers a revised version of the original report embodying the criticisms offered. And since, in the meantime, the underlying principles and techniques have been discussed in a separate theoretical study, they can be omitted. By referring to the basic study, “Valuation of Common Stocks,” published in The Analysts Journal of February, 1959, the reader will find a detailed account of the general economic reasoning and of the valuation techniques used here for appraising GM. The present study itself should, in turn, serve as a prototype for future appraisals of other stocks. This should make it possible, at the risk of hurting the paper industry, most of whose products seem to get engulfed in the mounting tonnage of financial literature, to give subsequent reports a condensed presentation.

A New Profession
The growing specialization so evident in medicine, law, engineering, and other professions, is also apparent in financial analysis. No single individual can absorb an adequate store of information about the technologies of all the different industries, the markets for their products, and the characteristics of their respective managements to pass competent judgment on the prospects of all and any individual corporations. Their diversities are so great that sometimes no true knowledge can be acquired beyond a handful of companies.

Considerable professional experience is needed to assemble significant facts from the welter of activities engaged in by a business enterprise, accurately interpreting and adjusting the reported figures of past and current profits, as well as expertly projecting them into the reasonably visible future. A different kind of skill is required for effectively using such facts, interpretations and projections as bases for an appraisal of value. Most of so-called valuations represent mere comparative pricing drawn from prevailing bid-and-asked ranges for similar properties-a borrowing of price tags worn in their lapels by other corporate Joneses. No objective measure of value, independent of going quotations, underlies this approach. Yet independence from the object to be measured is the main requirement of a good standard.

It seems likely that, a£ time goes on, the delineation between the two professions of corporate analysts and appraisers of stock values will become more sharply defined. Corporation finance and the economic theory of stock values have little in common. Even the practical experience and the educational backgrounds most desirable for efficient functioning in either field are different.

The Honorable John Dingell
U.S. House Building,
Rayburn House Building
Washington, D.C. 20515

Dear Mr. Dingell:

This letter is to comment upon the likely source for trading activity that will develop in any futures market involving stock indices. My background for this commentary is some thirty years of practice in various aspects of the investment business, including several years as a securities salesman. The last twenty-five years have been spent as a financial analyst, and I currently have the sole responsibility for an
equity portfolio that totals over $600 million. I am enclosing copies of several articles that relate to my experience in the investment field.

It is impossible to predict precisely what will develop in investment for speculative markets, and you should be wary of any who claim precision. I think the following represents a reasonable expectancy:

1. A role can be performed by the stock index future contract in aiding the risk-reducing efforts of the true investor. An investor may quite logically conclude that he can identify undervalued securities, but also conclude that he has no ability whatsoever to predict the short-term movements of the stock market:. This is the view I maintain in my own efforts in investment management. Such an investor may wish to “zero-out” market fluctuations and the continual shorting of a representative index offers him the chance to do just that. Presumably an investor with $10 million of undervalued equities and a constant short position of $10 million in the index will achieve the net rewards or penalties attributable solely to his skill in selection of specific securities, and have no worries that these results will be swamped – or even influenced by the fluctuations of the general market. Because there are costs involved-and because most investors believe that, over time long term, stock prices in general will advance – I think there are relatively few investment professionals who will operate in such a constantly hedged manner. But I also believe that it is a rational way to behave and that a few professionals who wish always to be “market neutral” in their attitude and behavior will do so.

2. As previously stated, I see a logical risk-reducing strategy that involves shorting the futures contract. I see no corresponding investment for hedging strategy whatsoever on the long side. By definition, therefore, a very maximum of 50% of the futures transactions can be entered into with the expectancy of risk reduction and not less than 50% (the long side) must act in a risk-accentuating or gambling manner.

3. The actual balance would be enormously different than this maximum 50/50 division between risk reducers and risk accentuates. The propensity to gamble is always increased by a large prize versus a small entry fee, no matter’ how poor the true odds may be. That’ s why Las Vegas casinos advertise big jackpots and why state lotteries headline big prizes. In securities, the unintelligent are seduced by the same approach in various ways, including: (a) “penny stocks”, which are “manufactured” by promoters precisely because they snare the gullible-creating dreams of enormous payoffs but with an actual group result of disaster, and (b) low margin requirements through which financial experience attributable to a large investment is achieved by committing a relatively small stake.

4. We have had many earlier experiences in our history in which the high total commitment/low down payment phenomenon has led to trouble. The most familiar, of course, is the stock market boom in the late 20′s that was accompanied and accentuated by 10% margins. Saner heads subsequently decided that there was nothing pro-social about such thin-margined speculation and that. rather than aiding capital markets, in the long run it hurt them. Accordingly, margin regulations were introduced and made a permanent part of the investing scene. The ability to speculate in stock indices with 10% down payments, of course, is simply a way around the margin requirements and will be immediately perceived as such by gamblers throughout the country.

Brokers, of course, favor new trading vehicles. Their enthusiasm tends to be in direct proportion to the amount of activity they expect. And the more the activity. the greater the cost to the public and the greater the amount of money that will be left behind by them to be spread among the brokerage industry. As each contract dies, the only business involved is that the loser pays the winner. Since the casino (the futures market and its supporting cast of brokers) gets paid a toll each time one of these transactions takes place. you can be sure that it will have a great interest in providing very large numbers of losers and winners. But it must be remembered that. for the players, it is the most clear sort of a “negative sum game”. Losses and gains cancel out before expenses; after expenses the net loss is substantial. In fact, unless such losses are quite substantial, the casino will terminate operations since the players’ net losses comprise the casino sole source of revenue. This “negative sum” aspect is in direct contrast to common stock investment generally, which has been a very substantial “positive sum game” over the years simply because the underlying companies, on balance, have earned substantial sums of’ money that eventually benefits their owners, the stockholders.

5. In my judgment. a very high percentage – probably at least 95% and more likely much higher – of the activity generated by these contracts will be strictly gambling in nature. You will have people wagering as to the short-term movements of the stock market and able to make fairly large wagers with fairly small sums. They will be encouraged to do so by brokers who will see rapid turnover of customers t capital – the best thing that can happen to a broker in terms of his immediate income. A great deal of money will be left behind by these 95% as the casino takes its bite from each transaction.

6. In the long run, gambling-dominated activities that are identified with traditional capital markets, and that leaves a very high percentage of those exposed to the activity burned, are not going to be good for capital markets. Even though people participating in such gambling activity are not investors and what they are buying really are not stocks, they still will feel that they have had a bad experience with the stock market. And after having been exposed to the worst face of capital markets, they understandably may, in the future, take a dim view of capital
markets generally. Certainly that has been the experience after previous waves of speculation. You might ask if the brokerage industry is not wise enough to look after its own long-term interests. History shows them to be myopic (witness the late 1960s); they often have been happiest when behavior was at its silliest. And many brokers are far more concerned with how much they gross this month than whether their clients – or, for that matter, the securities industry – prosper in
the long run.

We do not need more people gambling in non-essential instruments identified with the stock market in this country, nor brokers who encourage them to do so. What we need are investors and advisors who look at the long-term prospects for an enterprise and invest accordingly. We need the intelligent commitment of investment capital, not leveraged market wagers. The propensity to operate in the intelligent, pro-social sector of capital markets is deterred, not enhanced, by an active and exciting casino operating in somewhat the same arena, utilizing somewhat similar language and serviced by the same work force.

In addition, low-margined activity in stock-equivalents is inconsistent with expressed public policy as embodied in margin requirements. Although index futures have slight benefits to the investment professional wishing to “hedge out” the market. the net effect of high-volume futures markets in stock indices is likely to be overwhelmingly detrimental to the security-buying public and, therefore, in the long run to capital markets generally.

The below discussion will not at all be new and you will certainly recognize the issues of my concerns and I hope you choose to act on them in short duration.

From my perspective, $10 billion is the point at which size really begins to constrain performance, the consequence of a rapidly decreasing universe of investments. With respect to Fairholme, you must be thinking whether it makes sense to keep the fund open or otherwise to close it to new investors.

If to keep it open there must be clear evidence that in doing so, current investors will not suffer as a consequence. That is, the rate and duration of compounding returns that you can reasonably expect to earn while open to new investors must either be equal to or exceed the reasonably expected returns of Fairholme as a fund closed to new investors. Prior to the asininities of the last two years, size was an increasing concern, however the ensuing fiasco provided conditions which made incremental (external) capital attractive to all Fairholme investors. You addressed the question of size during a conference call last year, and I believe you were completely correct in your response, brief as it was. However, these conditions are not what they were a few months ago and I don’t know that a compelling argument can currently be made in favor of keeping the fund open-unless you are expanding your operations to international markets, you intend to employ future capital in the purchase of private businesses, or contributions are offset by distributions/redemption’s, but even under these circumstances it would be a difficult argument.

For about a year, I’ve been sharing my realization that there are two main risks in the investment world: the risk of losing money and the risk of missing opportunity. You can completely avoid one or the other, or you can compromise between the two, but you can’t eliminate both. One of the prominent features of investor psychology is that few people are able to (a) always balance the two risks or (b) emphasize the right one at the right time. Rather, at the extremes they usually obsess about the wrong one . . . and in so doing make the other the one deserving attention.

During bull markets, when asset prices are elevated, there’s great risk of losing money. And in bear markets, when everything’s at rock bottom, the real risk consists of missing opportunity. Everyone knows these things. But bull markets develop for the simple reason that most people are buying – ignoring the risk of loss in order to keep from missing opportunity – just when elevated prices imply losses later. Likewise, markets reach their lows because most people are selling, trying to avoid further losses and ignoring the bargains that are everywhere.

The Never-Ending Cycle

Why do people buy when they should sell, and sell when they should buy? The answer’s simple: emotion takes over. Price increases excite investors and encourage them to buy, and price declines scare them into selling.

When the economy and markets boom, people tend to assume more of the same is in the offing. They find little to worry about, other than the possibility that others will make more money than they will. Fear of loss recedes, and fear of opportunity costs takes over. Thus risk aversion evaporates and risk tolerance rises.

Risk aversion is absolutely essential in order for markets to function properly. When sufficient risk aversion is present, people shrink from riskier investments and prefer safer ones. Thus riskier investments have to appear to offer higher returns in order to attract capital. That’s as it should be.

But when people get excited about the prospect of easy money – even if from assets or investment strategies that have become far too popular, turning into overpriced manias – they frequently drop their risk aversion and adopt risk tolerance instead. Thus they swarm into the investment du jour without concern for its elevated price and risk. This behavior should constitute an important warning flag for prudent investors.

In the same way that expanded risk tolerance accompanies appreciated asset prices and contributes to the risk of loss, so does risk aversion tend to rise in times of depressed prices, increasing the risk of missed opportunity. When people refuse to buy assets regardless of their low prices, they miss out on the best, lowest-risk returns of the cycle.

Recent History – on the Upside
Just as the recent market cycle was extreme, so was the swing in attitudes regarding the “twin risks.” And thus so are the resultant learning opportunities.
Risk aversion was clearly inadequate in the years just before the onset of the crisis in mid-2007. In fact, I consider this the main cause of the crisis. (Last year, DealBook, the online business publication of The New York Times, asked me to write about what I thought had been behind the crisis. My article, entitled “Too Much Trust, Too Little Worry,” was published on October 5, 2009. It offers more on this subject should you want it.) Here’s the background regarding the early part of this decade:

Interest rates kept low by the Fed combined with the first three-year decline of stocks since the Depressionto reduce interest in traditional investments. As a result, investors shifted their focus to alternative and innovative investments such as buyouts, infrastructure, real estate, hedge funds and structured mortgage vehicles. In the low- return climate of the time, much of the appeal of these asset classes came from the fact that they promised higher returns thanks to their use of leverage, whether through borrowing, tranching or derivatives.
Given the high promised returns, investors forgot about (or chose to ignore) the ability of leverage to magnify losses as well as gains. Contributing to investors’ rosy view of leverage’s likely impact was their belief that risk had been banished by (a) the efficacy of the Fed and its “Greenspan put,” (b) the combination of securitization, disintermediation, tranching, decoupling and financial engineering, and (c) the “wall of liquidity” coming toward us from China and the oil producing nations.

For these reasons, few market participants were afraid of losing money. Most just worried about missing opportunity. The unattractive outlook for stocks and bonds meant investors would have to be aggressive and innovative if they were going to earn significant returns in the low-return environment. Thus risk aversion (a) was unnecessary and (b) would be counter-productive. “You’d better invest in this new financial product,” people were told. “If you don’t, you’ll miss out. And if you don’t and your competitor does – and it works – you’ll look out-of-step and fall behind.” When contemplating a virtuous circle without end, investors usually think of only one word: “buy.”

This describes the process through which fear of missed opportunity can overcome skepticism and prudence. And in this period, that’s what happened. No one worried about losing money. Fear of missed opportunity drove most investors, and Citibank’s Chuck Prince famously said, “. . . as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Although he worried about a possible decline in liquidity, he worried more about falling behind in the manic race to provide capital.
Recent History – on the Downside

The events from mid-2007 through late 2008 or early 2009 demonstrate the reverse in operation. The upward trend in home prices ground to a halt and subprime mortgages began to default in large numbers. Leveraged vehicles melted down. Credit became unavailable, and financial institutions needed rescuing. Recession caused spending to contract, and corporate profits declined. Bear Stearns, Merrill Lynch, AIG, Fannie Mae, Freddie Mac, Wachovia and Washington Mutual all required rescues. Bank capital, commercial paper and money market funds needed federal guarantees. After the bankruptcy of Lehman Brothers, people began to ponder the collapse of the financial system. As often happens in scary times, “possible” morphed into “probable,” or at least something very much worth worrying about.

Now a vicious circle replaced the virtuous one of just a few months earlier. And with its arrival, the fear of losing money replaced the fear of missing opportunity. As I’ve said before, I imagine most investors’ cry was, “I don’t care if I ever make a penny in the market again; I just don’t want to lose any more. Get me out!”
For most investors, no assumption was too negative to be true, and no potential return made the risk of loss worth bearing. High yield bonds at 19% yields. First lien leveraged loans at 18%. Investment grade bonds at 11%. None of these was sufficient to induce risk-taking.

In the middle of this decade we saw a manic period in which losses were unimaginable. The resultant shortages of risk aversion and skepticism caused investors to buy at highs and assume unprecedented risks in order to avoid missing opportunity. This was followed – as usual – by a collapse in which no negative event could be ruled out and no return was high enough to induce buying, all because investors wanted nothing other than to avoid losing money.

This cycle produced a treacherous, low-return period in which it was very hard to find investments promising good returns earned with safety, and then a period of collapse in which there were bargains everywhere but few investors possessed the requisite “dry powder” and intestinal fortitude with which to buy. That’s the background. Where do we stand today?
Signs of the Times

Optimism, adventurousness and unworried behavior characterized the pre-crisis period, and investor behavior reflected those attitudes. In my memo “It’s All Good” (July 16, 2007), just before the onset of the crisis, I mentioned some of the warning signs in the credit markets:
Unlike the historic norm, it’s routine today to issue CCC-rated bonds. It’s easy to borrow money for the express purpose of distributing cash to equity holders, magnifying the company’s leverage. It’s so easy to issue bonds with little or no creditor protection in the indenture that a label has been coined for them: “covenant-lite.” And it’s possible to issue bonds whose interest payments can be paid in more bonds at the option of the borrower.

The first requirement for an elevated opportunity in distressed debt is the unwise extension of credit, which I define as the making of loans which borrowers will be unable to service if things get a little worse. This happens when lenders fail to require a sufficient margin of safety. . . .
The default rate in the high yield bond universe is at a 25-year low on a rolling-twelve-month basis. Under such circumstances, how could the average supplier of capital be expected to maintain a high level of risk aversion and prudence, especially when doing so means ceding all the loan making to others? It’s not for nothing that they say “The worst of loans are made in the best of times.”
The inspiration for today’s memo came as my pile of clippings began to swell with indications that pre-crisis behavior is coming back. Here are excerpts from a few, with emphasis added in each case:

On covenant-lite loans –

Are debt investors just stupid? That might help explain why they’re buying covenant-lite loans again. These deals, which carry few restrictions on borrowers, became a standard bearer for easy money. They may have helped some companies limp through the downturn – but they’ve left lenders saddled with lots of risk and little return.
It’s easy to see why companies like covenant-lite loans. . . . But for owners of the debt, the attraction is far less clear beyond the familiar short-term reach for yield. . . .

My below statements address issues concerning the current statutes and regulations about the education requirements to sit for the Uniform CPA examination. There are significant problems and long term consequences that will result in the continuance of the current statute in this regard.

Currently, the underlying requirement to become a recognized public accountant has little to do with the extent to which an individual understands the technical aspects of accounting and relies instead on whether an individual attained an accounting degree from a university. Granted, many individuals with aspirations of becoming professional accountants will benefit from such course work, however, there are clear defects to restricting the total number of accountants to this group strictly. The United States is a great success in large part because an overwhelmingly large proportion of the really smart people around the world leave their place of birth for our country which increases our standard of living and global competitiveness. It would similarly not be wise to restrict intelligent individuals from entering the accounting profession in the future should they willingly wish to do so. These individuals will almost certainly (by definition) have much to contribute to the accounting profession, practically and theoretically.

Either you address the requirements for becoming a recognized accountant or you change the process by which accounting standards are established. As it currently stands, the former is certainly the easier problem to solve. Though there are certainly much better solutions to this problem, the board might consider adopting a policy from the legal profession.

California, Vermont, Virginia, and Wyoming have some form of “law office study” program that allow individuals previously tutored by an attorney or judge (practicing or retired) to take the bar exam. Maine and New York have similar programs, though these require at least some course work through a law school approved by the American Bar Association. Though there is considerable room for improvement, would it not make logical sense to adopt a similar approach for CPA exam requirement?

My last point is also the most important one I can not stress this enough. This concerns the lack of a diversified perspective in the methods and practice of future accounting principles and procedure. Limiting CPA candidates to individuals who only study institutional (Academic) accounting will in the longer term almost certainly result in a very narrow theoretical perspective for future CPA’s and for GAAP generally. As a consequence, there is certain to be a lack of needed input from intellectuals in other related disciplines as how to best adjust, relate, or solve future accounting issues, problems, and loopholes. Neglecting such an obvious defect within such an important institution is redundantly bad, yet it is a defect that can be quickly and painlessly resolved if promptly addressed.

Matthew C Pauls

—–END LETTER—

Agency Decision: Request denied.

Statement of Reasons for Decision: It is well established and accepted that formal education in accounting and related subjects provides valuable knowledge, skills, and abilities for the practice of public accounting that are not provided consistently by on-the-job experience. All states require formal education to be licensed as a certified public accountant (CPA), and formal education has been consistently included in the Uniform Accountancy Act (UAA) promulgated by the National Association of State Boards of Accountancy (NASBA). Also, because all other states require formal education, Virginia CPAs without formal education would not be able to practice in other states under substantial equivalency provisions in state statutes. Therefore, a regulatory change cannot be proposed by the board.
Agency Contact: Nancy Taylor Feldman, Executive Director, Board of Accountancy, 3600 West Broad Street, Suite 378, Richmond, VA 23230, telephone (804) 367-8505, FAX (804) 367-2174, or email boa@boa.virginia.gov.

Jason Zweig interviewed Seth Klarman and these are my [iluvbabyb] incomplete notes scribbled in haste and not direct quotes.

In value investing, you should think about investing Graham & Dodd style. Volatility works in your favor in terms of providing mispriced assets. Volatility shouldn’t be viewed as a problem. You should be seeking to buy bargains, and the best bargains often are found in the “hairiest” situations, such as in distressed securities or securities in litigation.

The business climate is more volatile today than during Graham’s time. What’s on the books today may not be as reliable as during Graham’s days. You need to look behind the numbers. There are more fads today in consumer goods i.e. Lady Gaga sneakers.

Seth Klarman previously worked for Michael Price and Max Heine of Mutual shares. The lesson he learned from Michael Price was the endless drive to get information by pulling all threads on a business in the efforts to seek value. Seth described Max Heine as a very kind person…he always had a smile and kind word for everyone in the shop from a junior analyst to the receptionist.

Seth was asked why so many value managers underperformed the market in 2008. He said over time value investing works and provides outperformance of 1-2% over the S&P 500. While this may seem like slender outperformance, it really adds up over time. There will be periods, however, when value investing underperforms. Many value investors were looking at the book value of banks and thinking they knew what was in it. However, instruments rated AAA weren’t all the same. During 2007/2008, investors needed to be more nimble and pull all the threads together on a business. Banks got cheap…and then cheaper. Many equity investors weren’t looking at the whole picture…they should have been looking at the credit bubble. Many investors also are pressured to be fully invested all the time. However, once the plug was pulled out of the tub in 2008, it was a long way down. Even for investors that were right, it wasn’t easy. Seth went on to discuss Michael Burry’s position as described in “The Big Short.” Burry had to defend his short position against his own investors.

Seth Klarman’s organization, Baupost, is organized to attract great clients, which is the key to maintaining investment success. His clients have a long-term perspective. They consist of highly knowledgeable families and sophisticated institutions. He described the ideal client as the one who agrees with them when they think they have had a good year and adds capital at times when Seth calls saying he is seeing good buying opportunities…which are usually the times other firms are facing redemptions. Seth was thus able to actively buy investments in 2008 when others had to sell. Many money managers had to liquidate positions just based on the fear or redemptions.
During 2008, Baupost went from zero exposure in distressed debt and mortgage securities to having 1/3 of their assets in distressed debt and mortgages, which subsequently grew to half of their total assets by 2009. They always look for mispriced securities and evaluate the opportunity costs and are prepared to act when opportunities become available.

Klarman quoted Ben Graham:
Those with the enterprise lack the money and those with the money lack the enterprises to buy stocks when they are cheap.

During the fourth quarter of 2008, it was easy for Klarman to buy securities. He doesn’t look at investments as pieces of paper like Cramer or Kudlow. He knows he is buying a fractional interest in a business. When you buy distressed bonds and you expect them to return to close to par, they become more compelling investments as the price goes down. If you have staying power and the conviction of your analysis, you won’t panic when prices drop.

Baupost always looks for compelling bargains and then stress tests all their assumptions, asking things like what happens to the investment if interest rates rise from 8% to 9%? They always buy with a margin of safety. One needs to have humility when investing–always worry about that which could go wrong with the investment.
An investor’s own confidence and temperament will impact their performances. One needs to be a highly disciplined buyer and seller and avoid the round trips. Temperament and a disciplined process will lead to successful investing.

Ben Graham said you need both cash and courage when investing. Having only one is not enough.

Klarman thinks indexing is a “horrible idea.” Most stocks run up prior to being put into the index, so the index is buying high. Klarman would rather buy stocks that are kicked out of the index, since they are likely to be a better value. For the average person, indexing may work but the entry point is critical.

Given the stock market rally since last year, Klarman is now worried of zero to low returns from the stock market for the next decade.
He compared the stock market to a Hostess Twinkie, which has totally artificial ingredients. Given the financial crisis, the market has been manipulated by the government with interest rates kept close to zero, TARP, Cash for Clunkers and Caulkers, the government buying dubious assets, etc. The government wants people to buy stocks to restore confidence. However, Klarman is worried about what the markets and the economy would look like if they hadn’t been manipulated…if the market wasn’t a Twinkie. The bailouts continue with the latest being put into place by the European governments. These bailouts probably won’t work.

Klarman said he is more worried about the world broadly than at any time in his career. There is now a new element to the investing game…will the dollar be worth anything if the government intervenes each time to prop things up? There are not enough dollars in the world to solve all the problems. He worries about all paper money. It is easy to imagine that politicians will find it easier to debase the currency with inflation than solve the hard problems. However, they can’t just keep kicking the can down the road. There is no free lunch and inflation is not zero.

The trouble is that we didn’t get “value” out of this crisis. There has been no Depression mentality. We’ve had “Just a Bad Week” mentality and there is still speculation going on.

We’re at a tipping point with sovereign debt. If investors think the U.S. will pay back debt, they won’t be worried. However, if they become worried, we could have failed Treasury auctions. The tipping point is invisible. Our Treasury Secretary is lulled into thinking we are AAA, but we have an eroding infrastructure and no fiscal responsibility.

How do you go bankrupt? Gradually and then suddenly…like Greece.
Commodities are not investments as they don’t produce cash flow. They only have value if you can sell them to a “greater fool.” They are only worth what some future buyer will pay for them. They are a speculation. Gold is somewhat different in that it is seen as a store of value. Investors might consider having some exposure to gold due to the worry of debasement of currency.

The investing game was checkers, now it is more like three-dimensional chess due to the potential destruction of dollars. Klarman is seeking an inexpensive hedge against dollar destruction as he is trying to protect against catastrophic tail risk. His way to hedge against inflation is through way out of the money puts on bonds. If interest rates go to double-digit ranges, he will make a lot of money. As long as the insurance is cheap enough, he will do it.

Baupost is managing $22 billion and said size is an anchor when it comes to investing. However, when he anticipated buying opportunities in early 2008, he called folks on his waiting list and allowed them to take advantage of the buying opportunities he was seeing so he could put greater capital to work.

He is worried a great deal about a double-dip recession due to debt morphing to sovereign risk. He now has about 30% in cash in his partnership. He will return the cash to clients if the cash increases much more and he doesn’t find any buying opportunities. He has no real lock ups in his hedge fund and calibrates his firm size to manage the right amount of the money dependent on market opportunities. His goal is excellence. He doesn’t want to take his company public as it would ruin the firm. He wants to retire at the end of his career knowing that he put his clients first, and he doesn’t care if he doesn’t charge as much as others.

Klarman had a bad visceral reaction to the Goldman hearings. Goldman’s hedging should have been celebrated as they were the Wall Street firm least likely to blow up thanks to the hedging. The world is a wild and woolly place. Brokers may have more conflicts of interest, but he knows Wall Street will always try to “rip out our eyeballs” on a trade. He said they go to Wall Street with their eyes wide open. He doesn’t know how to police Wall Street better. As market-makers, Wall Street doesn’t owe them any fiduciary duty.

Klarman would welcome more regulation if it helps the country. Limits on leverage and more disclosure would be fine. He wishes proprietary trading would go away. He knows firms front run Baupost trades. Bank capital requirements need to be higher. The bank rescue fund, however, has problems. It will penalize successful firms like J.P. Morgan due to their dumber competitors. He agreed with Bill Ackman who thinks if the bank’s equity gets wiped out, the subordinated debentures should be converted to equity.

At Baupost, they try to avoid groupthink. They recently had a conference in which they invited a variety of speakers. Most of them described the terrible problems we face; think the ECU will likely break up and that gold should be held. Following the meeting, members of Baupost questioned whether this was groupthink? They are very good at intellectual honesty and learn from their mistakes. There is no yelling at the firm over mistakes. They are aware of their biases in either direction.

Investors need to pick their poison. You either need to protect on the downside, which means you may not be at the party as long. Or you stay at the party and make money, but realize you will have a bad year or so. At Baupost, they prefer to be conservative. Klarman would rather underperform in a big bull market than get clobbered in a bear market.

In hiring folks, they try to find intellectually honest folks by asking them “What is the biggest mistake you ever made.” They also ask lots of ethical questions. Everyone they interview is smart, but they are seeking folks with idea fluency and high integrity.
Klarman believes short-sellers do better analysis than long-only investors since they have to due to the upward bias of the stock market over time. The Street is biased on the bullish side. Short sellers are the policeman of the market. It is not in the country’s interest to limit short-sellers. The one exception is on CDS buyers, who want a company to fail rather than recover and shout “Fire in the theatre” to make it happen. However, the burden should be on companies to not get into a position where their access to capital can be roiled by the short-sellers. GE was irresponsible in thinking they could always roll over their debt. However, if short sellers short on fundamentals and are wrong then Klarman welcomes them being stupid. He also said that if a computer wants to sell him a stock for a penny, he also would like that. When asked about how the flash crash hurt people who had in market orders, he thundered back that no one should ever put in a market order.

When asked about his asset allocation strategy, he just smiled since he doesn’t have one. He is highly opportunistic and buys what is out of favor. He goes where the trouble is…and can’t predict where that will be in the future.

He said “we make money when we buy bargains and count the profits later.” He currently is buying commercial real estate as the fundamentals are terrible. The government is winking at banks and telling them not to sell the real estate. While he isn’t currently making money in real estate, he is putting money to work in real estate. He is making money currently on the distressed debt he purchased two years ago which has nearly doubled in value.
His holding period is maturity for bonds and “forever” for stocks. This doesn’t mean that his turnover might be quicker if a bond rises rapidly from depressed prices to close to par.

When asked to describe a value company, he said there is no such thing. Price is the determinant for every investment.

When asked if he was worried about the counterparty risk for his out of the money puts, he said they worry about everything as there is risk in everything they do. However, they try to choose the best counterparties they can and require collateral posting.

When asked how he was confident enough to be fully invested in 2008, he said they over worry. They considered that the market could drop 40% and the economy could fall off the cliff. Even after considering a Depression scenario, they were still able to find things to buy like the bonds of captive auto finance companies, especially when they could pick up Ford bonds at depressed levels. They stress tested the loan portfolio and thought the bonds were worth significantly more than they were trading for as there wasn’t the same overbuilding in the auto industry as in the subprime housing market. As a result, there wasn’t the same deterioration in the loan portfolio. Klarman saw amazing upside in buying the bonds with Depression-proof downside, so he invested.

Credit risks remain real, however. The credit market rallies are now overblown especially in the junk market. Lessons were not learned even as investors stared into the abyss. Investors are back to drinking the Kool-Aid. There could be another collapse and people are not prepared for it.

Investors should think about disaster scenarios and prepare for them, although the preparation is more art than science. Klarman is trying to protect his client’s assets in the even the world gets really bad.
When asked if he plans to re-release his book, “Margin of Safety,” he said he has no immediate plans to do so although he has thought about doing it with a new introduction and perhaps a companion volume to raise money for charity. He just hasn’t had time.

When asked about other book recommendations, he gave the following:
The Intelligent Investor-Ben Graham
You Can Be a Stock Market Genius-Joel Greenblatt
The Conservative Investor-Marty Whitman
Too Big to Fail-Andrew Sorkin
Anything written by Jim Grant, Roger Lowenstein and Michael Lewis
He said folks should never stop reading as history doesn’t repeat but it rhymes, and in finance, progress is cyclical.

(FORTUNE Magazine) – WARREN BUFFETT, chairman of Berkshire Hathaway, calls the conglomerate his ”canvas,” and shortly, when its annual report comes out, the world will learn precisely what kind of picture this legendary investor painted in the tumultuous year of 1987. A preview: As a work of art, the year was not a minor Buffett. Berkshire — whose shareholders, I wish to say quickly and happily, have long included me — chalked up a $464 million gain in net worth, an advance of no less than 19.5%. That is somewhat below the 23.1% annual average that Buffett has recorded since taking over the company 23 years ago. But in a year in which many professional investors had their heads handed to them, this latest example of Buffett brushwork has to rank as one more masterpiece. The annual report, which readers always comb for Buffett’s once-a-year revelations about what he has been doing in the securities markets, will carry two special pieces of news. First, Buffett, who bought $700 million of Salomon Inc. redeemable convertible preferred stock for Berkshire just before the October crash, makes it clear in his chairman’s letter that he is solidly behind the investment bank’s chairman, John Gutfreund. That should put an end to the persistent rumors about divisions between the two men (see box). Second, Buffett reveals that Berkshire began buying short-term Texaco bonds last year after the company went into bankruptcy, at a point when many other investors were bailing out of the bonds. At year-end Berkshire had an unrealized profit in the Texaco securities. But both that holding and the Salomon preferred (which Buffett figures to have been worth about $685 million at year-end) are carried at cost on Berkshire’s books and were nonevents as far as the company’s 1987 record is concerned. Behind that record — behind Buffett, in fact — is a double-barreled story, which in all the words that have been written about him has usually been told as single-bore only. Most of the business world knows about Warren Buffett the investor. The Wizard of Omaha; the stock-picking genius who turned $9,800, most of it saved from paper routes, into a personal net worth that is today more than $1.6 billion; the man whose superlative, long-running investment performance has become ever more difficult for the efficient-market camp to explain away as luck. That Buffett was certainly abroad in the land in 1987. Having said for more than two years that he could not find reasonably priced stocks to buy for Berkshire, Buffett came into October 19 wearing heavy armor, owning almost no common equities besides those of three companies that he thinks of as ”permanent” parts of Berkshire’s portfolio. All three, though they fell substantially in the crash, were standouts for the entire year: Geico, the auto insurance company, was up by 12%; Washington Post by 20%; Capital Cities/ ABC by 29%. Not bad for Buffett the investor. But the other craftsman at work in Berkshire is Buffett the businessman, a buyer and manager of companies and a fellow whose skill is not understood widely at all. In effect, this guy grinds out the yardage, while Buffett the investor throws bombs. In 1987 the Berkshire offense was nicely balanced: The investor produced $249 million (after allowances for taxes) in realized and unrealized gains; the businessman generated $215 million in after-tax operating earnings from Berkshire’s stable of businesses, for that total of $464 million. The operating earnings were more than the net income of Dow Jones, or Pillsbury, or Corning Glass Works. The vehicle through which all this got done, Berkshire, had a stock price of around $12 in 1965 when Buffett took control. It rose to a high of $4,200 in 1987 and was recently about $3,100. Buffett, a witty, straightforward man of 57, owns 42% of the company; his wife, Susan, 55, another 3%. Berkshire had more than $2 billion in revenues in 1987, will probably rank around 30th in FORTUNE’s annual list of the largest diversified services companies, and is powerfully strange in its makeup. At Berkshire’s heart is a large property-and-casualty insurance operation composed of several unfamous companies (such as National Indemnity), which generates ”float” that Buffett invests. Beyond insurance, Berkshire owns a set of sizable businesses that Buffett bought, one by one, and that he calls his Sainted Seven. They are the Buffalo News; Fechheimer Brothers, a Cincinnati manufacturer and distributor of uniforms; the Nebraska Furniture Mart, an Omaha retailer that sells more home furnishings than any other store in the country; See’s Candies, the dominant producer and retailer of candy in California; and three operations that Buffett took into the fold when Berkshire bought Scott & Fetzer of Cleveland in 1986: World Book, Kirby vacuum cleaners, and a diversified manufacturing operation that makes industrial products such as compressors and burners. A MOTLEY CREW, yes — but in his 1987 annual report, Buffett the businessman comes out of the closet to point out just how good these enterprises and their managers are. Had the Sainted Seven operated as a single business in 1987, he says, they would have employed $175 million in equity capital, paid only a net $2 million in interest, and earned, after taxes, $100 million. That’s a return on equity of 57%, and it is exceptional. As Buffett says, ”You’ll seldom see such a percentage anywhere, let alone at large, diversified companies with nominal leverage.” A business school professor trying gamely a few years ago to reconcile the efficient-market hypothesis with Buffett’s success at investing called him ”a five-sigma event,” a statistical aberration so rare it practically never happens. In the buying and managing of whole companies, he may well be a phenomenon equally uncommon. He brings to buying the same acuity and discipline he brings to investing. As a manager he disregards form and convention and sticks to business principles that he calls ”simple, old, and few.” The Berkshire companies, for example, never lose sight of what they’re trying to do. Says Buffett: ”If we get on the main line, New York to Chicago, we don’t get off at Altoona and take side trips. We also have a reverence for logic around here. But what we do is not beyond anybody else’s competence. I feel the same way about managing that I do about investing: It’s just not necessary to do extraordinary things to get extraordinary results.” My credentials for writing about both Buffetts, the investor and the businessman, are unusual. Besides having been a staff member of this magazine for more than 30 years, I have been a friend of Buffett’s for more than 20. I do some editing of his annual report, which is why I know what it’s going to say. I am an admirer of Buffett’s. In this article, because it has been written by a friend, you can expect two things: an inside look at how Warren Buffett operates and something less than total objectivity. But here is an incontestable fact: Buffett brings an immense mental brilliance to everything he does. Michael Goldberg, 41, who runs Berkshire’s insurance operations and occupies the office next to Buffett’s in Omaha, thinks that he saw people as smart at the Bronx High School of Science, ”but they all went into math and physics.” Buffett’s intellectual power is totally focused on business, which he loves and knows incredible amounts about. Says Goldberg: ”He is constantly examining all that he hears: ‘Is it consistent and plausible? Is it wrong?’ He has a model in his head of the whole world. The computer there compares every new fact with all that he’s ever experienced and knows about — and says, ‘What does this mean for us?’ ” For Berkshire, that is. Buffett owns a few stocks personally but spends little time thinking about them. Says he: ”My ego is wrapped up with Berkshire. No question about that.” Meeting him, most people would see little evidence of ego at all. Buffett is down-to-earth, ordinary looking in a pleasant, solid Midwestern way — as a private eye, for example, he could blend into any crowd — and in matters of dress not snappy. He likes McDonald’s and cherry Cokes and dislikes large parties and small talk. But in the right setting he can be highly gregarious and even a ham: This winter, at a Cap Cities management meeting, he donned a Salvation Army uniform, tooted away on a horn, and serenaded the company’s chairman, Thomas Murphy, by singing, ”What a friend I have in Murphy,” featuring lyrics he had written. SOMETIMES, and particularly on intellectual subjects, Buffett talks with great intensity and speed, trying to keep up with the gyrator in his mind. When he was young, he was terrified of public speaking. So he forced himself to take a Dale Carnegie course, filled, he says, ”with other people equally pitiful.” Today he gives speeches with ease, drawing them entirely from an outline in his head — no written speech, no notes — and lacing them with an inexhaustible supply of quips, examples, and analogies (for which a professional writer would kill). In his work Buffett has not let the complexities of his thinking prevent him from forming a very simple view of life. The key point about the two Buffetts, the investor and the businessman, is that they look at the ownership of businesses in exactly the same way. The investor sees the chance to buy portions of a business in the stock market at a price below intrinsic value — that is, below what a rational buyer would pay to own the entire establishment. The manager sees the chance to buy the whole business at no more than that intrinsic value. The kind of merchandise that Buffett wants is simply described also: ”good businesses.” To him that essentially means operations with strong franchises, above-average returns on equity, a relatively small need for capital investment, and the capacity therefore to throw off cash. That list may sound like motherhood and apple pie. But finding and buying such businesses isn’t easy; Buffett likens the hunt to bagging ”rare and fast-moving elephants.” He has avoided straying from his strict criteria. The Sainted Seven all possess the characteristics of a good business. So do the companies in which Buffett owns stock, such as Geico, Washington Post, and Cap Cities. In his annual reports Buffett regularly extols the managers of all these companies, most of whom rival him — if anyone can — in their conviction that working is fun. He devoutly wishes to keep them fanatics. ”Wonderful businesses run by wonderful people” is his description of the scene he wants to look down on as a chief executive. But he believes that over the years his largest mistakes in investing have been the failure to buy certain ”good business” stocks just because he couldn’t stomach the quality of management. ”I’d have been better off trusting the businesses,” he says. So in the stocks he has sometimes held, though not in the businesses he owns directly, he has on occasion gritted his teeth and tolerated a fair amount of management inanity. A few years ago, when he owned many more stocks than now, he complained to a friend about the absurdities of an annual report he had just read, describing the content as misleading and self-serving of management and ”enough to make you throw up.” The friend said, ”And yet you’re in the stock.” Yes, was his answer: ”I want to be in businesses so good that even a dummy can make money.” Naturally, good businesses do not come cheap, particularly not today when the whole world has caught on to their attributes. But Buffett has been consistently shrewd as a buyer — he simply will not overpay — and patient in waiting for opportunities. He regularly puts an ”ad” in his annual report explaining what kind of businesses he’d like to buy. ”For the right business — and the right people — we can provide a good home,” he says. Some folks of the right sort, by the name of Heldman, read that ad and brought him their uniform business, Fechheimer, in 1986. The business had only about $6 million in profits, which is an operation smaller than Buffett thinks ideal. But the Heldmans seemed so completely the kind of managers he looks for — ”likable, talented, honest, and goal-driven” is his description — that he made the acquisition and is delighted he did. IN BUYING at least one business, the Buffalo News, Buffett was particularly farseeing. Both the Washington Post Co. and Chicago’s Tribune Co. turned it down when it came up for sale in 1977, perhaps discouraged because it was an evening paper, a dwindling breed. The News was also a six-day publisher, with no Sunday edition and revenue stream, competing against a seven-day publisher, the Courier-Express. But the News was the stronger of the two during the week, and Buffett concluded the paper had the makings to do well if it could establish a Sunday edition. Buying the paper for $32.5 million, he immediately started to publish on Sunday. The News’s special introductory offers to subscribers and advertisers prompted the Courier-Express to bring an antitrust suit, which he defeated. Both papers went for years losing money — and then, in 1982, the Courier- Express gave up and closed down. Last year the News, as a flourishing monopoly paper, made $39 million in pretax operating profits and certainly did not do it by stinting on editorial copy. The paper delivers one page of news for every page of advertising, a proportion not matched by any other prosperous paper of its size or larger. Because Buffett loves journalism — he says that if he had not been an investor, he might well have picked journalism as a career — the News is probably his favorite property. The oddity of Buffett’s intense focus on good businesses is that he came late to that philosophy, after a couple of decades of mucking around and making prodigious amounts of money anyway. As a kid in Omaha, he was precocious and fascinated by anything having to do with numbers and money. His father, Howard Buffett, a stockbroker whom the son adored, affectionately called him ”Fireball.” He virtually memorized a library book, One Thousand Ways to Make $1000, fantasizing in particular about penny weighing machines. He pictured himself starting with a single machine, pyramiding his take into thousands more, and turning himself into the world’s youngest millionaire. In Presbyterian church he calculated the life spans of the composers of hymns, investigating whether their religious calling had rewarded them with extra years of life (his conclusion: no). At age 11 he and a friend moved into more secular pursuits, putting out a horse-racing handicapping sheet under the name Stable-Boy Selections. Through it all he thought about stocks. He got his first books on the market when he was 8, bought his first stock (Cities Service preferred) at 11, and went on to experiment with all manner of trading methodologies. He was a teenage stock ”chartist” for a while, and later a market timer. His base from 1943 on was Washington, where his family moved upon Howard Buffett’s election to Congress. Deeply homesick for Omaha, young Warren once ran away from home and also got disastrous grades for a while in junior high, even in the math at which he was naturally gifted. Only when his father threatened to make Warren give up his lucrative and much-loved paper routes did his grades improve. Graduating from high school at 16, Buffett went through two years at the University of Pennsylvania and then transferred to the University of Nebraska. There, in early 1950, while a senior, he read Benjamin Graham’s newly published book, The Intelligent Investor. The book encouraged the reader to pay attention to the intrinsic value of companies and to invest with a ”margin of safety,” and to Buffett it all made enormous sense. To this day there is a Graham flavor to Buffett’s only articulated rules of investment: ”The first rule is not to lose. The second rule is not to forget the first rule.” In the summer of 1950, having applied to Harvard business school, Buffett took the train to Chicago and was interviewed by a local alum. What this representative of higher learning surveyed, Buffett says, was ”a scrawny 19- year-old who looked 16 and had the social poise of a 12-year-old.” After ten minutes the interview was over, and so were Buffett’s prospects of going to Harvard. The rejection stung. But Buffett now considers it the luckiest thing ever to have happened to him, because upon returning to Omaha he chanced to learn that Ben Graham was teaching at Columbia’s business school, and immediately — and this time successfully — applied. Another student in Graham’s class was William Ruane, who today runs the top-performing Sequoia Fund and is one of Buffett’s closest friends. Ruane says that a kind of intellectual electricity coursed between Graham and Buffett from the start and that the rest of the class was mainly an audience. At the end of the school year Buffett offered to work for Graham’s investment company, Graham-Newman, for nothing — ”but Ben,” says Buffett, ”made his customary calculation of value to price and said no.” Buffett did not succeed in getting a job offer from Graham until 1954, when he started at Graham-Newman as jack-of-all-trades and student of his mentor’s mechanistic, value-based investment techniques. Basically, Graham looked for ”bargains,” which he rigidly defined as stocks that could be bought at no more than two-thirds of their net working capital. Most companies, he figured, could be liquidated for at least their net working capital; so in buying for still less, he saw himself building in the necessary margin of safety. Today few stocks would meet Graham’s standards; in the early 1950s, many did. Buffett returned to Omaha in 1956 at age 25, imbued with Graham’s theories and ready to embark upon the course that was to make him rich and famous. Assembling $105,000 in limited partnership funds from a few family members and friends, he started Buffett Partnership Ltd. The economics of the partnership were simple: The limited partners earned 6% on their funds and got 75% of all profits made in addition; Buffett, as general partner, got the remaining 25%. The partnership earned impressive profits from the start, and as word spread about this young man’s abilities, new partners climbed aboard, bearing money. When Buffett decided in 1969 to disband the partnership, having grown disenchanted with a market that had turned wildly speculative, he had $100 million under management, of which $25 million was his own — most of it the fruits of his share of the profits. Over the 13 years of the partnership, he had compounded its funds at an average annual rate of 29.5%. That record is the forerunner of his performance with Berkshire: 23.1%. The drama of his Berkshire record is that he has scored colossal gains on the company’s capital while retaining 100% of its earnings — Berkshire pays no dividends. This means that he has had to find investment outlets for a vigorously expanding amount of money. The company’s equity at year-end was $2.8 billion, an impressive figure to be compounding at superlative rates. Despite the outstanding record of the partnership, Buffett feels today that he managed its money with only part of his senses at work. In his 1987 annual report Buffett laments 20 misspent years, a period including all of the partnership days, during which he searched for ”bargains” — and, alas, ”had the misfortune to find some.” His punishment, he says, was ”an education in the economics of short-line farm implement manufacturers, third- place department stores, and New England textile manufacturers.” The farm implement company was Dempster Mill Manufacturing of Nebraska; the department store was Hochschild Kohn of Baltimore; and the textile manufacturer was Berkshire Hathaway itself. The Buffett partnership got in and out of Dempster and Hochschild Kohn quickly during the 1960s. Berkshire Hathaway, the textile business, of which the partnership bought control for around $11 million, was a more lasting problem. Buffett nursed the business for 20 years while deploring the benightedness that had taken him into such industrial bogs as men’s suit linings, in which he was just another commodity operator with no edge of any kind. Periodically Buffett would explain in his annual report why he stayed in an operation with such poor economics. The business, he said, was a major employer in New Bedford, Massachusetts; the operation’s managers had been straightforward with him and as able as the managers of his successful businesses; the unions had been reasonable. But finally, in 1985, Buffett closed the operation, unwilling to make the capital investments that would have been necessary if he was even to subsist in this deeply discouraging business. A few years earlier, for his annual report, Buffett wrote a line that has become famous: ”With few exceptions, when a manager with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” As a requiem for Buffett’s textile experience, the sentiment will do nicely. In his own mind, also, this is not just a case of a relatively small investment gone bad. Calculating what Berkshire might have earned if he had not made the bet on textiles, he thinks of the opportunity cost as being around $500 million. OCCASIONALLY during his misspent years, Buffett would be drawn toward a good – business and, as if startled into unusual action, would plunge abnormal amounts into the opportunity. In 1951, then investing only his own money and mainly gravitating toward such ”bargains” as Timely Clothes and Des Moines Railway, Buffett became fascinated by Geico, whose low distribution costs and ability to sign up a better set of policyholders than other insurers gave it a crucial advantage. Though the company did not begin to meet Ben Graham’s mathematical tests, Buffett put $10,000 — around two-thirds of his net worth — into Geico stock. He sold a year later at a 50% profit and did not again own the company until 1976. By then Geico was magnitudes larger but near bankruptcy because it had miscalculated its claim costs and was underpricing. Buffett thought, however, that the company’s competitive advantage was intact and that a newly named chief executive, John J. Byrne, could probably restore the company’s health. Over five years Buffett invested $45 million in Geico. Byrne did the job, becoming a close friend of Buffett’s and often seeking his advice. Geico is today an industry star, and Berkshire’s stake is worth $800 million. On another occasion, in 1964, while running the partnership, Buffett barreled into American Express stock at the time of the so-called salad oil scandal. An Amexco subsidiary that issued warehouse receipts was found to have certified the existence of mountainous quantities of oil that did not exist. On a worst-case basis American Express might have emerged from that crisis with no net worth. The company’s stock plunged. Ben Graham would have scorned the stock because, by his definitions, it offered no margin of safety. But Buffett assessed the franchises embodied in the company’s charge card and traveler’s checks businesses and concluded these were assets that could carry Amexco through almost any storm. Buffett had an unwritten rule at the time that he would not put more than 25% of the partnership’s money into one security. He broke the rule for American Express, committing 40%, which was $13 million. Some two years later he sold out at a $20 million profit. Buffett considers himself to have been nudged, prodded, and shoved toward a steady, rather than intermittent, appreciation of good businesses by Charles T. Munger, 64, vice chairman of Berkshire and the ”Charlie” of Buffett’s annual reports. In the U.S. corporate system, vice chairmen have a way of often not being important. That is decidedly not the case at Berkshire Hathaway. Munger’s mental ability is probably up to Buffett’s, and the two can talk as equals. They differ, however, in political views — Munger is a traditional Republican, Buffett a fiscally conservative Democrat — and in demeanor. Though sometimes cutting in his annual report, Buffett employs great tact when doling out criticism in person. Munger can be incisively frank. Last year, chairing the annual meeting of Wesco, a California savings and loan 80% owned by Berkshire, Munger delivered a self-appraisal: ”In my whole life nobody has ever accused me of being humble. Although humility is a trait I much admire, I don’t think I quite got my full share.” Like Buffett, Munger is a native of Omaha, but as boys the two did not know each other. After getting the equivalent of a college degree in the Army Air Force and graduating from Harvard law school, Munger went to Los Angeles, where he started the law firm now known as Munger Tolles & Olson. On a visit back to Omaha in 1959, Munger attended a dinner party that also included Buffett. Munger had heard tales of this 29-year-old who was remaking the Omaha investment scene and was prepared to be unimpressed. Instead, he was bowled over by Buffett’s intellect. ”I would have to say,” says Munger, ”that I recognized almost instantly what a remarkable person Warren is.” Buffett’s reaction was that of a proselytizer. Convinced that the law was a slow boat to wealth, he began arguing that Munger should give up his practice and start his own investment partnership. Finally, in 1962, Munger made the move, though he hedged his bets by also keeping a hand in the law. His partnership was much smaller than Buffett’s, more highly concentrated, and much more volatile. Nonetheless, in the partnership’s 13-year history, extending through 1975, Munger achieved an annual average gain, compounded, of 19.8%. His wealth expanded as Buffett expected: Among other holdings, he owns nearly 2% of Berkshire, recently worth about $70 million. When he met Buffett, Munger had already formed strong opinions about the chasms between good businesses and bad. He served as a director of an International Harvester dealership in Bakersfield and saw how difficult it was to fix up an intrinsically mediocre business; as an Angeleno, he observed the splendid prosperity of the Los Angeles Times; in his head he did not carry a creed about ”bargains” that had to be unlearned. So in conversations with Buffett over the years he preached the virtues of good businesses, and in time & Buffett totally accepted the logic of the case. By 1972, Blue Chip Stamps, a Berkshire affiliate that has since been merged into the parent, was paying three times book value to buy See’s Candies, and the good-business era was launched. ”I have been shaped tremendously by Charlie,” says Buffett. ”Boy, if I had listened only to Ben, would I ever be a lot poorer.” Last year at a Los Angeles party, Munger’s dinner partner turned to him and coolly asked, ”Tell me, what one quality most accounts for your enormous success?” Recalling this delicious moment later, Munger said, ”Can you imagine such a wonderful question? And so I looked at this marvelous creature — whom I certainly hope to sit by at every dinner party — and said, ‘I’m rational. That’s the answer. I’m rational.’ ” The anecdote has a particular relevance because rationality is also the quality that Buffett thinks distinguishes the style with which he runs Berkshire — and the quality he often finds lacking at other corporations. ESSENTIALLY, BUFFETT, as chief executive officer, does the jobs for which he judges himself to have special competence: capital allocation, pricing in certain instances, and analysis of the numbers coming out of the operating divisions. ”Warren would die if he didn’t get the monthly figures,” says Munger. As long as the numbers are looking as they should, though, Buffett does not poke into operations, but rather leaves his managers free to run their businesses as their intelligence tells them to. When he talks about the kind of companies he wishes to buy, Buffett always stipulates that they must come in the door with their own good management because, he says, ”We can’t supply management, and won’t.” He is solicitous of the talent working for him. Most of the people heading his operations are rich and could retire. In what he writes and says, Buffett never lets them forget that he regards their continued hard work as one of the great rewards of his life. Buffett sets the pay of the top man in an operating company but plays no role in compensation beyond that. All the top people are paid through incentive plans that Buffett carefully tailors to achieve whatever objectives fit — higher profit margins in a business, for example, or reductions in the capital it employs, or improved underwriting results for the insurance operation and more ”float” for Buffett to invest. The incentives do not have ceilings. And so it is that Mike Goldberg, of the insurance business, earned / $2.6 million in 1986 and $3.1 million last year. On the other hand, in 1983 and 1984, when the insurance business was rotten, he earned his base salary, which is roughly $100,000. Looking ahead, and running an insurance business that is souring rapidly, Goldberg thinks he could be back at base pay again by 1990. Buffett earns base pay by all definitions: $100,000 per year. AT THAT PRICE he offers undoubtedly the best-value consulting business around. His operating managers can call him whenever they wish with whatever concerns they have, and none pass up the opportunity to draw on his encyclopedic knowledge of the way businesses work. Stanford Lipsey, publisher of the Buffalo News, tends to talk to Buffett once or twice a week, usually at night. Ralph Schey, chairman of Scott Fetzer, says he saves up his questions, checking in with Buffett every week or two. With the family Buffett usually refers to as ”the amazing Blumkins,” who run the Nebraska Furniture Mart, the drill is dinner, held every few weeks at an Omaha restaurant. The Blumkins attending usually include Louie, 68, and his sons: Ron, 39; Irv, 35; and Steve, 33. The matriarch of the family and chairman of the Furniture Mart is Rose Blumkin, who emigrated from Russia as a young woman, started a tiny furniture store that offered rock-bottom prices — her motto is ”Sell cheap and tell the truth” — and built it into a business that last year did $140 million in sales. At age 94, she still works seven days a week in the carpet department. Buffett says in his new annual report that she is clearly gathering speed and ”may well reach her full potential in another five or ten years. Therefore, I’ve persuaded the Board to scrap our mandatory-retirement-at -100 policy.” And it’s about time, he adds: ”With every passing year, this policy has seemed sillier to me.” He jests, true, but Buffett simply does not regard age as having any bearing on how able a manager is. Perhaps because he has tended to buy good managements and stick with them, he has worked over the years with an unusually large number of older executives and treasured their abilities. ”My God,” he says, ”good managers are so scarce I can’t afford the luxury of letting them go just because they’ve added a year to their age.” Louis Vincenti, chairman of Wesco until shortly before he died at age 79, used to periodically question whether he should not be training a successor. Buffett would turn him off with a big smile: ”Say, Louie, how’s your mother feeling – these days?” The Berkshire companies do not in any way practice togetherness. There are no companywide management meetings and most of the operating heads do not know one another, or at most have exchanged a few words. Buffett has never visited Fechheimer in Cincinnati. Charles ”Chuck” Huggins, president of See’s for the 16 years Berkshire has owned it, has never been to Omaha. Naturally, Buffett does not impose any systems of management on the heads of the operating companies, who are free to be as loose or structured as they wish. Schey, 63, the chief executive of Scott Fetzer (1987 sales: $740 million), is a graduate of Harvard business school and uses the full panoply of management tools: detailed budgets, strategic plans, annual conclaves of his executives. A few hundred miles away at Fechheimer (1987 sales: $75 million), Robert Heldman, 69, and brother George, 67, sit down every morning in a cluttered conference room and go through all the mail that comes into headquarters. ”Somebody slits it open for us, though,” says Bob Heldman, not wanting to be thought an extremist. As the latest businesses to be acquired by Berkshire, Scott Fetzer and Fechheimer have been getting accustomed to dealing with this unusual boss in Omaha. A few years ago, before selling to Berkshire, Schey had attempted to lead a management buyout that would have taken Scott Fetzer, a listed company, private. But Ivan Boesky meddled in the deal, the company’s fate grew uncertain, and in time Buffett wrote Schey an exploratory letter. Buffett and Munger met with Schey on a Tuesday in Chicago, made an offer on the spot, and waived the ”due diligence” rigmarole that acquirers usually demand. One week later Scott Fetzer’s board approved the sale. SCHEY REGARDS that episode as illustrative of the lack of bureaucracy he encounters in working with Buffett. ”If I couldn’t own Scott Fetzer myself, this is the next best thing” — better, he feels, than being a public company. In that life he had institutional investors on his neck and a board that tended to be ultracautious about authorizing major moves. Schey’s prize example is his current intention to decentralize the World Book organization, which has been hunkered down at Chicago’s Merchandise Mart forever. Schey’s old board, he says, would probably have resisted the risk of restructuring; Buffett waved him ahead. Schey says, with a grin, that Buffett has also solved the recurring problems that Scott Fetzer had finding a use for all the cash ) its very good businesses throw off. ”Now,” says Schey, ”I just ship the money to Warren.” The Heldmans at Fechheimer sold 80% of their company in 1981 to a venture capital group and, on the advice of an investment counselor, put part of the proceeds into Berkshire Hathaway stock. When the venture group decided in 1985 to get out, Bob Heldman recalled Buffett’s annual report pitch for acquisitions and negotiated his way into the Berkshire fold. Though their relationship with the venture capitalists was pleasant, the Heldmans thoroughly disliked six New York board meetings they had to attend every year and also the lavish expense of those meetings. Buffett, says Bob Heldman, is ”terrific.” Is there anything that you wish he would do differently? ”Well,” says Heldman, ”he never second-guesses us. Maybe he should do more of that.” Buffett roars upon learning of this complaint: ”Believe me, if they needed second-guessing — which they definitely don’t — they’d get it.” Buffett can actually be very tough. He recalls landing on one of the operating divisions a few years ago when it put in new ”labor saving” data- processing equipment and nonetheless let its head count in the accounting department go from 16 1/2 to 22 1/2. For all of his laid-back management style, Buffett knows about numbers like that and deplores them. There is a right-size staff for any operation, he thinks, whether business is good or bad, and he is totally impatient with unnecessary costs and managers who allow them to materialize. He says: ”Whenever I read about some company undertaking a cost-cutting program, I know it’s not a company that really knows what costs are all about. Spurts don’t work in this area. The really good manager does not wake up in the morning and say, ‘This is the day I’m going to cut costs,’ any more than he wakes up and decides to practice breathing.” WHEN THEY CRITICIZE him, which they do only mildly, Buffett’s operating managers tend to think him too rational and demanding about numbers. No one can quite imagine him paying up for a small ”seed” business with a possible future but no present. Buffett and Munger are not in the least suffused with animal spirits, and they do not even consider making discretionary capital expenditures — say for flashy offices — that aren’t going to do them any economic good. Neither are they inventors. Says Buffett: ”We don’t have the skill to be. Above all, I guess you’d say we have a strong sense of our own limitations.” They are not timid, though, about prices. Buffett works with the heads of both See’s and the Buffalo News in setting prices once a year, and he has tended to be aggressive. A chief executive, he says, can bring a perspective to pricing that a divisional manager cannot: ”The manager has just one business. His equation tells him that if he prices a little too low, it’s not that serious. But if he prices too high, he sees himself screwing up the only thing in his life. And no one knows what raising prices will do. For the manager, it’s all Russian roulette. For the chief executive, with more than one thing in his life, it really isn’t. So I would argue that someone with wide experience and distance from the scene should set prices in certain cases.” Buffett extends his own experience to one other kind of pricing: the setting of premium rates for large-risk insurance policies, such as product liability coverage. That game is one of seven- and eight-figure premiums, probabilities, and years of ”float.” It is a game made to order for Buffett, who tends to do a few calculations in his head and come up with a bid. He does not own a calculator — ”or a computer or abacus,” he says — and would never see himself as needing any kind of mathematical crutch. Though the point is hardly provable, he must be the only billionaire who still does his own income tax. At his office in Omaha, in fact, he does what he pleases, leading an unhurried, unhassled, largely unscheduled life. Counting the boss, headquarters includes only 11 people, and that’s a shade too many, Buffett thinks. The place is kept efficient by his assistant, Gladys Kaiser, 59, who has worked for him 20 years and for whom he wishes perpetual life. ”If Gladys can’t have it,” Buffett says, ”I’m not sure I want it either.” He spends hours at a stretch in his office, reading, talking on the phone, and, in the December to March period, agonizing over his annual report, whose fame is one of the profound satisfactions of his life. He is not in the least moody. ”When I talk to him,” says Chuck Huggins of See’s, ”he’s always up, always positive.” But in general he is something of a loner in his office, apt there to be less communicative and gracious than when talking on the phone to friends or the operating managers. Munger thinks it would not work for the managers to be physically in the same place as Buffett. ”He’s so damn smart and quick that people who are around him all the time feel a constant mental pressure from trying to keep up. You’d need a strong ego to survive in headquarters.” Goldberg, whose ego has been put to the test, says it’s not easy. ”I’ve had a chance to see someone in action who can’t be believed. The negative is: How do you ever think much of your own abilities after being around Warren Buffett?” When Buffett is buying stocks, he often interrupts other phone conversations to talk on three direct lines that connect him with brokers. But he will say in the new annual report that he has not found much to do in stocks lately. ”During the break in October,” he writes, ”a few stocks fell to prices that interested us, but we were unable to make meaningful purchases before they rebounded.” At year-end Berkshire held no stock positions worth more than $50 million, other than its ”permanent” holdings and a short-term $78 million arbitrage position in Allegis, which is radically restructuring. The friends that Buffett talks to on the phone and often sees include a few other chief executives, among them the Washington Post’s Katharine Graham and Cap Cities’ Murphy. Graham has leaned on him for advice for years. As she says, ”I’m working on my degree from the Buffett school of business.” Buffett thinks Murphy the finest executive in the country, but Murphy tunes in for advice also. ”I talk to him about all the important aspects of my business,” says Murphy. ”He’s never negative and always supportive. He’s got such a massive mind and such a remarkable ability to absorb information. You know, we’re supposed to be pretty good managers around here, but his newspaper outdoes ours.” Buffett himself thinks that his investing abilities have been helped by his business experiences, and vice versa. ”Investing,” he says, ”gives you this wide exposure that you just can’t get directly. As an investor, you learn where the surprises are — in retailing, for example, where business can just evaporate. And if you’re a really good investor you go back and pick up 50 years of vicarious experience. You also learn capital allocation. Instead of putting water in just one bucket, you learn what other buckets have to offer.” ”On the other hand,” he goes on, ”could you really explain to a fish what it’s like to walk on land? One day on land is worth a thousand years of talking about it, and one day running a business has exactly the same kind of value. Running a business really makes you feel down to your toes what it’s like.” His summary judgment: It’s been awfully good to have a foot in both camps.

”We have no special insights regarding the direction or future profitability of investment banking,” says Warren Buffett in the forthcoming Berkshire Hathaway annual report for 1987. ”What we do have a strong feeling about is the ability and integrity of John Gutfreund, CEO of Salomon Inc.” With that declaration, Buffett takes a hatchet to the rumors that have been sweeping Wall Street for months, in which he is typically presented as wanting (a) Gutfreund out and (b) someone like William Simon in. Since Buffett has a policy of not making hostile moves against the managements of companies he invests in, the rumors were always a reach. But the timing of Buffett’s push into Salomon last year almost guaranteed that stories would begin to fly. On October 1 he put $700 million of Berkshire’s money, his biggest investment ever, into Salomon redeemable convertible preferred. The stock pays 9%, is convertible after three years into Salomon common at $38, and if not converted will be redeemed over five years beginning in 1995. The rub is the $38. Salomon stock was around $33 when Buffett made the deal. After October 19 it sank to almost $16 and was recently about $23. The crash transformed the Street’s perception of Buffett’s move. He was originally thought to have bought a dream security, worth more than he paid. Salomon, it was said, had panicked at the prospect that raider Ronald Perelman might try a takeover and had allowed Buffett his own bit of banditry. The postcrash reading, which takes into account many defections and much turmoil at Salomon, is that Buffett has bought a bummer and that his whole credibility as an investor is at stake. Buffett notes in his annual report that the economics of investment banking are far less predictable than those of most businesses in which he has major commitments. He says that’s one reason he went for a convertible preferred. But he also sounds serene in outlook: ”We believe there is a reasonable likelihood that a leading, high-quality capital-raising and market-making operation can average good returns on equity. If so, our conversion right will eventually prove valuable.” By the way, he adds, he’d like to buy more convertible preferreds of the Salomon variety, which sounds like serenity squared. The most fascinating aspect of Buffett’s Salomon investment is that it puts him in bed with Wall Streeters, whose general greed he has scored in the past. In his 1982 annual report he derided the inclination of investment bankers to provide whatever advice would bring in the most income. ”Don’t ask your barber whether you need a haircut,” he said. But this year’s report suggests he finds Gutfreund’s barbering a cut above: In dealings with Gutfreund, Buffett says, he has seen him advise clients not to take steps they were itching to take, even though that caused Salomon to miss out on large fees. Note that Buffett’s description of Salomon’s business does not include those Wall Street buzzwords ”merchant banking.” To Buffett, the bridge loans that are the current merchant-banking fad and that grease the way for many leveraged buyouts all too often look like dangerous commitments — debt so junior that it is almost equity. He and his associate, Charles Munger, are directors of Salomon and may well argue that the firm should avoid making bridge loans. But, says Buffett, ”if John Gutfreund ends up thinking he wants to do them, we will support him. We don’t go into companies with the thought of effecting a lot of change. That doesn’t work any better in investments than it does in marriages.”

Buffett:Abacus was made the subject of an SEC investigation. There’s been misreporting, non-intentional obviously, but there has been a misreporting of the nature of the transaction, in the majority of the reports that I’ve read. This will take a little time, but I think it’s an important subject. I would like to go through that transaction first and then we’ll get to have further questions.

There were four losers, I will focus on two of them. Goldman Sachs itself was a loser, but they didn’t intend on being a loser. They intended to sell a portion of the transaction, but were unable to sell. The main loser in terms of actual cash value was a very large bank in Europe by the name of ABN AMRO. They subsequently became part of the Royal Bank of Scotland.

Why did they lose money? They lost money because they, in effect, guaranteed the credit of another company ACA. ABN was in the business of judging credits, deciding which credits they would accept themselves and which credits they would guarantee. In effect, they did something in the insurance world called fronting, which really means guaranteeing the transaction of another party. We have done that many times at Berkshire, we get paid for it. People may not want the credit of XYZ insurance company, but they say they’ll take a policy of XYZ company, if we (Berkshire) guarantee it. Berkshire has been paid a lot of money over the years and Charlie you can remember years back in the 1970′s when we lost a lot of money because we guaranteed some not so honest people and we lost a lot of money, Lloyd’s of all things, but they found ways not to pay it.

So ABN agreed to guarantee about $900 million worth of credit for ACA. That is in the SEC complaint that they received about 17 basis points, that is 17 hundredths of one percent. They got it about $1,600,000 and the company they guaranteed went broke, so they had to pay the $900 million. It is a little hard for me to get terribly sympathetic.

ACA was a bond insurer and they started out as a municipal bond insurer. ACA, MBIA…all those companies started out insuring municipal bonds. It was a big business insuring municipal bonds and then all of a sudden their margins started to get squeezed so instead of accepting lower profits they got into the business of insuring structured credits and other kinds of activities. I described their activities a couple years ago as being a little bit like Mae West who said, “I was like snow white, but I drifted.” Almost all of these bond insurers drifted to make a little bit more money.

ACA did it, they all did it, and they got into trouble, every one of them.

Is there anything wrong with bond insurance? No, but you better know what you’re doing. Interestingly enough, when these other guys got in trouble we (Berkshire Hathaway) got into the municipal bond insurance business and reassured things that were almost identical to what ACA and others had insured, the difference being we thought we knew a little bit more about what we were doing and we got paid better for what we were doing and we stayed away from things we didn’t understand.

Here’s something we did ensure to give you a better idea. Let me describe a deal to you.

A large investment bank came to us a couple of years ago (Lehman Brothers). At the time we were not insuring bonds regularly, but we were insuring the bonds of a local utility in Nebraska and insuring the bonds of the Methodist Hospital about six miles from here. We made the agreement that if the Methodist Hospital could not pay the liabilities of its bonds that we would pay. The total issue was between $100 million $200 million. Now a couple of years ago, Lehman came to us and asked us to take a look at this portfolio.

(Projection of a slide displayed of several states and related amounts to be insured.)

As you can see there’s $1.1 billion for Florida and only $200 million for the state of California…

Lehman asked us to insure the bonds of these states for the next 10 years and if any of these states don’t pay then we’d have to pay. I looked at the list and we had to decide (a) whether we knew enough to insure them and (b) what premium to charge. It was that simple. We didn’t have to insure them, we could just say forget it, we don’t know enough to make the decision. But we knew enough to make the decision and collected about $160 million to insure those bonds.

This gets to the crux of the SEC’s case against Golden.
Lehman came to us with this list, we didn’t create them, another party came to us. From a buyers perspective there are about 4 possibilities to consider.

Lehman Brothers might:
(1) own these bonds and want protection against the credit
(2) they might be negative on the bond market and effectively be shorting these bonds.
(3) a customer of Lehman that owns these bonds may have wanted to buy protection against the credit.
(4) or a customer of Lehman might be negative on these bonds and wants to short them.

We don’t care what scenario exists. It is our job to value the risk of these bonds
and to arrive at a proper premium. If Ben Bernanke were on the other side of the trade it wouldn’t make any difference to me. If I have to care about who’s on the other side of the trade I should not be in this business.

So, in effect, we did with these bonds exactly what ACA did with the bonds that were presented to them, but ACA was presented with a list of about 120 and they decided they’d insure about 50 of them, then went back and negotiated to insure 30 more. So they insured only a handful of the total list, whereas we looked at the list and took the list and was totally the other guys list.

In the case of the Abacus transaction it was a negotiation. In the end the bonds that were included in the Abacus transaction all went south very quickly. That wasn’t so obvious that they would go south in 2007 as you can see by studying something like the ABX index, but the housing bubble started blowing up in 2007. Now there could be problems in states we insured, there could be pension obligations or other problems and maybe the guy going short knows more about that than we do, but that’s our problem. In the case of ACA they had teams of people looking at these bonds and at Berkshire we only had a couple people. if I lose a lot of money on our transactions I’m not going to go to the other guy and say you took advantage of me. If it’s John Paulson, I’m not going to complain. No one forced me to enter into these contracts, we made the decision to do so.

I think the central part of the argument is that Paulson knew more about the bonds than the bond insurer did and my guess is that ACA employ more people than John Paulson. In retrospect it just turned out to be dumb bond insurance. I don’t see what difference it makes whether it was John Paulson on the other side of the deal or someone else.

I’d like to get Charlie’s comments from a legal perspective and I haven’t really spoken to him too much about this, charlie.

Munger:My attitude is pretty simple. This was a 3-2 decision by the SEC, under circumstances where they normally require unanimous consent. if I would have voted, I would’ve been one of the two not the three who voted to move forward against Paulson.

Buffett:I’ve heard something about the ACA deal claiming that investors were taken advantage of, but ACA was the parent company of the bond insurer that entered into the deal with Paulson. ACA lost money because they were bond insurer.
—–

Responding to a question about Berkshire’s Investment in Goldman Sachs Preferreds.

Buffett:
Ironically the negative publicity to Goldman is probably in our best interest in certain ways, because we have $5 billion in preferred stock that pays us $500 million year. Golden has the legal right to call these preferreds at 110% of par. Anytime they want to send Berkshire 5.5 billion, they can, and we would turn around and put that money in some very short-term security, which would probably under today’s conditions yield something very small, so every day that Goldman does not call their preferred’s is beneficial to us. Goldman pays us $15 every second, so as we sit here tick, tick, tick, tick… $50,000 We don’t want that to go away. These ticks occur at night, on weekends…

We love the Goldman investment.

Advice to Goldman:
When some kind of transgression is found or alleged we go by the motto
(1) get it right
(2) get it fast
(3) get out
(4) get it over

But, get it right is number one. If you don’t have your facts right you’re going to get killed. I do not hold the allegations against Goldman as significant, but if it leads to something more serious, I’ll look at the situation at that time.

With respect to the Abacus situation I don’t see much of an argument. We trade with Goldman but we don’t hire them as investment advisors. We make our own decisions. They could very well be selling short securities they sell us. They don’t need to explain to us what their doing. Their operating in a non-fiduciary capacity and we know that.

We are ignoring the lessons of “Poor Richard” rather, more importantly, Benjamin Franklin. It might be wise for the individuals of the United States to reconsider why we have been successful in the past and what will drive us to failure.

Poor Richard:

The Indies have not made Spain rich, because her outgoes are greater than her incomes.

Many a one, for the sake of finery on the back, have gone with a hungry belly and half-starved their families. Silks and satins, scarlet and velvets, put out the kitchen fire, as Poor Richard says.

“These are not the necessaries of life; they can scarcely be called the conveniences; and yet, only because they look pretty, how many want to have them! By these, and other extravagances, the genteel are reduced to poverty, and forced to borrow of those whom they formerly despised, but who, through industry and frugality, have maintained their standing.

“But what madness must it be to run in debt for these superfluities? We are offered by the terms of this sale, six months’ credit; and that, perhaps, has induced some of us to attend it, because we cannot spare the ready money, and hope now to be fine without it. But, ah! think what you do when, I you run in debt, you give to another power over your liberty. If you cannot pay at the time, you will be ashamed to see your creditor; you will be in fear when you speak to him; you will make poor, pitiful, sneaking excuses, and, by degrees, come to lose your veracity, and sink into base, downright lying; for the second vice is lying, the first is running in debt, as Poor Richard says.

“What would you think that government, who should issue an edict forbidding you to dress as you should please, on pain of imprisonment or servitude? Would you not say that you were free, have a right to dress as you please, and that such an edict would be a breach of your privileges, and such a government tyrannical? And yet you are about to put yourself under such tyranny, when you run in debt for such dress! Your creditor has authority, at his pleasure, to deprive you of your liberty, by confining you in gaol till you shall be able to pay him. When you have got your bargain, you may, perhaps, think little of payment; but, as Poor Richard says, Creditors have better memories than debtors; creditors are a superstitious sect, great observers of set days and times.

He that goes a borrowing goes a sorrowing.

What maintains one vice would bring up two children. You may think, perhaps, that a little tea, or a little punch now and then, -diet a little more costly, clothes a little finer, and a little’ entertainment now and then, can be no great matter; but remember, Many a little makes a mickle. Beware of little expenses; A small leak will sink a great ship.

The leak is an old one. We would be wise to plug it sooner rather than later.